UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED MARCH 30, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ___________ TO __________.
COMMISSION FILE NUMBER: 0-21876
FUNCO, INC.
(Exact name of registrant as specified in its charter)
MINNESOTA 41-1609563
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
10120 WEST 76TH STREET
MINNEAPOLIS, MN 55344
(Address and zip code of principal executive offices)
(612) 946-8883
(Issuer's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $.01 PAR VALUE
(Title of Class)
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the preceding 12 months (or for such
shorter period that the registrant was required to file such reports) and (2)
has been subject to such filing requirements for the past 90 days.
Yes _X_ No ___
Indicate by check if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant's knowledge in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [x]
Aggregate market value of Common Stock held by nonaffiliates as of June 17,
1997: $64,337,631
Number of shares of Common Stock outstanding as of the close of business on
June 17, 1997: 6,098,781
DOCUMENTS INCORPORATED BY REFERENCE
Proxy Statement for Annual Meeting of Shareholders, August 1, 1997 ("Proxy
Statement") PART III
PART I
ITEM 1.
BUSINESS
GENERAL
Funco, Inc. (the "Company") was incorporated in March 1988 under the laws of the
State of Minnesota. The Company, through its FUNCOLAND(R) stores, is a leading
specialty retailer of new and previously played interactive entertainment. The
Company's products include a wide selection of video games, related hardware and
accessories, with each store offering approximately 3,000 different game titles.
The majority of the Company's merchandise is previously played and is sold at
approximately half the price for which these products originally sold. The
FUNCOLAND store concept provides consumers an opportunity to sell their video
games they no longer play and apply that value toward other previously played or
new video games. The Company emphasizes personalized attention to its customers
and provides game sampling areas to assist in selection of new and previously
played games. At March 30, 1997, the Company operated 188 retail stores in
twelve major metropolitan areas. This store strategy is complemented by Funco's
mail order operation and its publication of GAME INFORMER(R), a video game
magazine with over 160,000 paid subscribers.
COMPANY STRATEGY
During fiscal 1997, the Company established its first West Coast market by
successfully opening 9 San Francisco Bay area stores. In addition to this new
market, at fiscal year end the Company operated 80 East Coast Region stores and
99 Central Region stores.
The Company's primary goal is to strengthen its position as a leading provider
of new and previously played interactive entertainment. During fiscal 1998 the
Company's emphasis will be on further growing its store base and increasing
profitability. The Company has recently initiated expansion into the Seattle
market, adding to its West Coast presence. The Company expects to open several
new markets during fiscal 1998 and will also add stores in existing markets,
with store count growing to approximately 225 by fiscal year end. In future
years the Company expects to further enhance its position through greater
increases in both the number of FUNCOLAND stores and the number of metropolitan
areas in which the stores are located. The Company targets selected metropolitan
areas based on market size, demographics and competitive factors.
The Company believes it has achieved substantial economies in the areas of
marketing and advertising, product distribution, store interior build-outs and
lease terms as a result of implementing a rapid, multiple-site rollout strategy
in selected metropolitan areas. This strategy positions the Company as the
dominant retailer of previously played video game merchandise in a metropolitan
area, enabling it to compete more effectively against generally smaller
competitors. In the new product category the Company frequently competes with
large nationally recognized retailers.
MERCHANDISING
The Company's stores offer substantial value to the video game consumer by
providing (i) a broad selection of previously played video game merchandise at
approximately half the price for which these games were originally sold and (ii)
an opportunity to resell video games that they no longer play and to apply the
proceeds towards the purchase of other games.
The Company's net sales are generated primarily through the sale of a wide
selection of Sony PlayStation, Nintendo and Sega video games, hardware and
accessories. The majority of the Company's sales is previously played
merchandise. The Company also offers new products to its customers, including
games, hardware and accessories. To assure customers that they will not
sacrifice quality or performance when purchasing previously played merchandise,
the Company provides warranties on all of its products. The Company's video game
selection includes the newer 32 and 64-bit product categories, as well as the
older 8 and 16-bit product categories. The Company's inventory of individual
titles is frequently modified to adapt to changing consumer preferences for
particular games, game systems and categories of games. Games fall into one of
several categories including sports, adventure, action, role playing and family
games. Because manufacturers generally limit the number of game cartridges or
CD's produced for any given game title, after a time, many older collectors'
titles offered by the Company are unavailable through retailers of exclusively
new merchandise. The majority of the Company's top selling previously played
games, as measured by unit sales, are no longer readily available new. The
Company also offers subscriptions to GAME INFORMER magazine through its retail
operations.
The Company provides the opportunity for video game players to resell video game
merchandise in exchange for store credit or a check from corporate headquarters.
The price the Company will pay for each item of previously played merchandise is
posted in the stores and is periodically adjusted, providing video game
enthusiasts a reason to stop in on a regular basis. By providing a secondary
market for video games and equipment, the Company reduces the overall cost of
playing video games to the consumer and encourages the purchase of new games and
upgrades to more advanced systems. The Company believes that this active
secondary market helps to expand consumer interest in video games and increases
overall purchases of video games and equipment.
PRODUCT SUPPLY
The Company obtains most of its previously played inventory from its customers,
primarily from purchases made in its retail operations. Over the last seven
years the Company has developed a model to manage its previously played
inventory and to maintain the desired product mix. The Company adjusts the price
that it pays for each item of previously played merchandise (the "bid" price)
regularly and currently adjusts its selling price (the "ask" price) once each
month. All purchase and selling prices are determined by corporate management
and are not subject to change at the store level. By adjusting these bid and ask
prices, the Company strives to maintain substantial Company-wide control over
both its inventory levels as well as its gross margins on an item-by-item basis.
Through its bid/ask model, the Company accumulates inventory to stock new stores
as they open and to meet holiday season demand. All new stores are initially set
up with inventory shipped from the Company's centralized distribution center.
This start-up inventory includes previously played merchandise accumulated from
customers at the store level as well as new products purchased directly from
video game licensees and manufacturers. Once a store opens, approximately 80% of
its previously played stock needs are satisfied by merchandise purchased from
the store's local customer trading base, with the remainder supplied from the
Company's distribution center. Periodic pullbacks of inventory from the
Company's stores to the distribution center provide merchandise for
store-to-store stock balancing and new store openings.
The Company purchases new interactive entertainment hardware, software and
accessories from the industry's leading licensees and manufacturers. The Company
has established strong relationships within the industry and has successfully
participated in the launch of a number of new products. The Company expects that
new product pricing, availability, acceptance and market penetration will affect
future operating results.
STORE LOCATIONS AND SITE SELECTION
At March 30, 1997, the Company operated 188 FUNCOLAND stores in twelve
metropolitan markets. The number of stores open in these markets at each
respective year end date is summarized below:
MARCH 30, MARCH 31, APRIL 2, APRIL 3, APRIL 4,
1997 1996 1995 1994 1993
--------- --------- -------- -------- --------
Central Region:
Minneapolis 14 13 13 12 11
Dallas 12 12 14 14 14
Houston 8 7 9 - -
Chicago 30 30 34 32 27
Milwaukee 6 6 6 5 4
Detroit 24 21 21 14 -
Kansas City 5 5 5 - -
--------- --------- -------- -------- --------
Subtotal Central Region 99 94 102 77 56
East Coast Region:
New York Metropolitan Area 36 37 38 29 -
Philadelphia 16 15 16 2 -
Baltimore/Washington, DC 15 16 16 2 -
Boston 13 11 10 - -
--------- --------- -------- -------- --------
Subtotal East Coast Region 80 79 80 33 -
West Coast Region:
San Francisco 9 - - - -
--------- --------- -------- -------- --------
Total Stores 188 173 182 110 56
========= ========= ======== ======== ========
FUNCOLAND stores are generally located in "power strip centers" near major
regional malls or in high-density retail areas. These locations provide
visibility, easy access and high traffic counts. The Company targets centers
that are well recognized, well maintained and have a balanced tenant mix.
STORE LAYOUT AND DESIGN
FUNCOLAND stores range in size from 1,000 square feet to 2,700 square feet, with
most stores containing approximately 1,700 square feet. The basic design of a
FUNCOLAND store is generally consistent throughout the Company and is intended
to create a bright and colorful shopping environment with well-merchandised
shelves emphasizing the store's broad product selection. Stores are equipped
with several television monitors that display operating video games, creating an
environment conducive to video game purchase. Each store is also equipped with
several video game sampling areas that provide the consumer the opportunity to
play games before purchase.
MAIL ORDER
The Company's mail order operation is primarily engaged in selling previously
played video games and related equipment from its headquarters in Eden Prairie,
Minnesota. Throughout the year, the Company periodically mails a video game
catalog to individuals on the mailing list. In addition, the Company places
direct response advertising in several leading video game magazines. Net sales
from mail order for fiscal 1997 accounted for approximately 5% of net retail
sales.
GAME INFORMER MAGAZINE
The Company publishes GAME INFORMER, a monthly video game magazine, featuring
reviews of new title releases, tips and secrets about existing games and news
regarding current developments in interactive entertainment. For its March 1997
issue, the magazine had over 160,000 paid subscribers. GAME INFORMER is
published by Sunrise Publications, Inc., a wholly-owned subsidiary of Funco,
Inc.
COMPETITION
The interactive home entertainment retailing business currently can be divided
into two major segments: retailers of new merchandise and retailers of
previously played merchandise. Although both segments compete for the consumer's
business, they also support one another by maintaining consumer interest in
interactive home entertainment. Because many game titles are no longer available
from retailers of new merchandise, consumers seeking to purchase these games
must generally enter the previously played market.
New interactive entertainment product is sold primarily through mass
merchandisers such as Target, Wal-Mart and K-Mart; national retail chains that
specialize in computer software such as Babbages Etc. and Electronics Boutique;
and national department stores, toy stores and consumer electronics superstores.
Many competitors, including Babbages Etc., Toys "R" Us and Electronics Boutique
now, like FUNCOLAND, feature trade-in opportunities through which consumers are
able to realize value for their previously played product. There can be no
assurance that these retailers, many of whom have substantially greater
resources than the Company, will not move more aggressively into the previously
played market and become direct competitors. Additionally, retailers which
deeply discount new merchandise may compete with Funco's previously played
product offerings.
Previously played video game merchandise is sold primarily through local and
regional companies that buy and sell previously played video game merchandise.
With 188 stores in twelve metropolitan areas at March 30, 1997, the Company is
the nation's leading specialty retailer of previously played video game
merchandise. The Company is aware of several smaller companies, including one
with approximately 40 stores, that buy and sell previously played video games by
mail or through retail stores. At least one of these companies plans to use
franchising as a means of expanding its store base. In its current geographic
markets, the Company frequently competes with small operations that buy and sell
previously played video game merchandise and with movie/video rental outlets
which may sell games.
The Company anticipates that as it expands into new markets it will be required
to compete with other providers. The Company believes that its stores compete on
the basis of broad selection, price, customer service and convenience and that
its stores measure favorably against competition with respect to each of these
factors. The Company's market penetration strategy is intended to establish a
strong presence in each chosen market, thereby discouraging potential
competitors from entering such markets.
As sellers of new and previously played games, the Company may also compete with
movie/video rental outlets that rent or sell previously played games. For some
consumers, renting a video game for multiple day rates is an alternative to
buying new or previously played games. The Company believes that video game
rental outlets have not historically been substantial competitors of the Company
and that they have, in fact, supported the sale of previously played games by
maintaining consumer interest in interactive home entertainment and by providing
consumers the opportunity to sample games before purchase. However, there can be
no assurance that the rental or sale of video games in these rental outlets will
not become a significant source of competition to the Company in the future.
The market for interactive entertainment products is characterized by rapidly
changing technology and user preferences, evolving industry standards and
frequent new product introductions. Game systems introduced in the past two
years include Sony PlayStation, Nintendo 64 and Sega Saturn.
Although the Company believes that its concept of creating a secondary market
for previously played games and equipment applies to the systems currently on
the market, there can be no assurance that future systems and technology will
gain market acceptance with consumers or that the Company can successfully
operate a secondary market for such future products.
To date, video games and equipment have been distributed primarily through
retail stores. Other distribution channels have included the Sega Channel, which
is a pay cable channel available to a wide audience of cable equipped households
in select markets. Other distribution channels for interactive entertainment
would include on-line services such as delivered through the Internet. Although
the Company believes that alternate delivery systems tend to broaden exposure
and promote interactive entertainment, there can be no assurance that any such
means of distributing games will not reduce sales of interactive video games and
equipment through retail stores. Any such reduction could materially adversely
affect the Company's financial and operating results.
EMPLOYEES
At March 30, 1997, the Company had 588 full-time employees, including 160
corporate and administrative personnel and 428 store personnel, and 506
part-time employees. During seasonal peak periods, the Company adds temporary
part-time employees.
TRADEMARKS AND SERVICE MARKS
FUNCOLAND(R), FUNCO LAND(R), FUNCO(R), GAME INFORMER(R), EXPERIENCE THE FUN AT
FUNCOLAND(R), FUNCOLAND YOUR SOURCE FOR INTERACTIVE ENTERTAINMENT(R), BRING HOME
THE FUN(R), FUNCOLAND FUN CLUB(R), AMERICA'S PLACE TO SHOP FOR VIDEO GAMES(R),
FUNCOLAND NATIONAL VIDEO GAME CHAMPIONSHIPS(R) and SUNRISE PUBLICATIONS(R) have
been registered as trademarks and service marks by the Company with the United
States Patent and Trademark Office (the "USPTO"). The Company has also filed
applications with the USPTO for federal registration of certain other trademarks
and service marks used in connection with its business, including FUNCOLAND(TM)
(stylized letters mark). The Company believes these trademarks and service marks
are of considerable value to its business and important to its marketing
efforts.
ITEM 2.
PROPERTIES
All of the Company's retail stores are leased. Leases typically provide for an
initial three-year term with varying options for renewal. The Company operated
188 locations at March 30, 1997 including 11 with leases under negotiation. The
Company's retail store leases effective as of March 30, 1997 expire as follows:
DURING NUMBER OF
FISCAL YEAR EXPIRING LEASES
----------- ---------------
1998 63
1999 39
2000 61
2001 11
2002 and beyond 3
For information regarding minimum lease payments, see Note 3 of Notes to
Consolidated Financial Statements. The Company believes that the termination of
any particular lease would not have a material adverse effect on its business
and that similar locations on comparable terms would be available within the
same or in a contiguous market area.
In addition to its retail outlets, the Company leases a 50,000 square foot
distribution and office facility in Eden Prairie, Minnesota, where its corporate
headquarters is also located. This lease expires June 30, 2002. The Company has
a five-year renewal option for this space.
ITEM 3.
LEGAL PROCEEDINGS
The Company and its Chief Executive Officer were originally named as defendants
in a civil lawsuit filed on August 17, 1995 in the United States District Court,
District of Minnesota, entitled CHRISTOPHER CANNON V. FUNCO, INC. AND DAVID R.
POMIJE. This was a putative class action in which the named plaintiff in the
Class Action Complaint purported to represent a class of all purchasers of the
Company's common stock during the putative class period of May 18, 1994 through
December 15, 1994. On October 18, 1996 the court dismissed the state common law
claims with prejudice and dismissed the federal securities claims without
prejudice, giving the plaintiff leave to file an Amended Complaint. The
plaintiff filed an Amended Complaint on January 6, 1997.
The Amended Complaint is a similarly styled class action suit and alleges the
Company's share price was artificially inflated, asserting various claims under
the Securities Exchange Act of 1934, as amended. Plaintiff seeks damages in an
unspecified amount plus costs and attorney's fees. The Company and its Chief
Executive Officer continue to believe that the claim is entirely without merit,
deny liability and intend to defend the litigation vigorously. The Company and
its Chief Executive Officer filed a motion to dismiss the Amended Class Action
Complaint in its entirety.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS
No matter was submitted to a vote of security-holders during the quarter ended
March 30, 1997.
PART II
ITEM 5.
MARKET FOR REGISTRANT'S COMMON EQUITY AND
RELATED STOCKHOLDER MATTERS
Common Stock
The Company's common stock was first traded publicly on August 12,
1992. The stock is listed on the NASDAQ national market system under the symbol
FNCO. The table below presents the high and low closing prices of the Company's
common stock as reported by NASDAQ.
1997 Fiscal Quarter 1996 Fiscal Quarter
High Low High Low
First $ 9 1/2 $ 4 $ 6 $ 3 5/8
Second 9 1/4 6 1/8 6 1/8 3 7/8
Third 10 8 1/8 4 1/2 2 5/8
Fourth 18 8 3/8 4 1/2 2 5/8
At June 17, 1997, there were 6,098,781 shares of common stock
outstanding, held by 259 shareholders of record. The Company has not paid any
cash dividends on its common stock and does not anticipate paying cash dividends
in the foreseeable future. Under the Company's current bank credit agreement,
the Company is prohibited from paying dividends.
In fiscal 1997 the Company sold 85,000 shares of its common stock to two
individuals upon the exercise of warrants that had been issued to the
underwriter of the Company's initial public offering. The exercise price per
warrant was $6.00, resulting in net proceeds to the Company of $510,000. No
underwriting discounts or commissions were paid in connection with such sales.
In connection with these transactions, the Company relied on the exemption under
Section 4(2) of the Securities Act of 1933 as sales not involving a public
offering.
ITEM 6.
SELECTED CONSOLIDATED FINANCIAL DATA
(in thousands, except share and per share data and number of stores)
YEAR ENDED
------------------------------------------------------------------
MARCH 30, MARCH 31, APRIL 2, APRIL 3, APRIL 4,
1997 1996 1995 1994 1993
---------- ---------- ---------- ---------- ----------
Statement of Operations Data
Net sales $ 120,555 $ 81,382 $ 80,365 $ 50,490 $ 20,534
Net income (loss) $ 5,350 $ 205 $ (1,275) $ 880 $ (520)
Net income (loss) per share $ .86 $ .03 $ (.22) $ .15 $ (.12)
Weighted average number of
shares 6,197,383 5,971,194 5,786,719 5,807,798 4,164,247
Stores open at end of year 188 173 182 110 56
Balance Sheet Data
Total assets $ 31,745 $ 25,668 $ 23,160 $ 24,707 $ 7,553
Long-term obligations $ 91 $ 115 $ 485 $ 557 $ 457
Shareholders' equity $ 24,318 $ 18,071 $ 17,800 $ 18,653 $ 4,484
The above selected financial data should be read in conjunction with the
consolidated financial statements and related notes beginning on page 15 of this
report and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" appearing in Item 7 hereof.
ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The Company has grown from three retail stores at the end of fiscal 1991 to 188
at the end of fiscal 1997. The Company has 99 stores in the Central Region,
which includes Minneapolis, Dallas, Houston, Chicago, Milwaukee, Detroit and
Kansas City; 80 stores in the East Coast Region, which includes the New York
Metropolitan Area, Philadelphia, Baltimore/Washington, DC and Boston and 9
stores in the West Coast Region, currently consisting of the San Francisco Bay
area.
The Company's business is seasonal with a majority of net sales generated in the
third and fourth fiscal quarters, which include the holiday selling season. In
addition to sales seasonality, the Company's quarterly results are also impacted
by new product introductions and by the number and timing of new store openings.
Because of the seasonality of the Company's business and the factors mentioned
above, results for any quarter are not necessarily indicative of the results
that may be achieved for a full fiscal year.
In addition to seasonality, key factors affecting net sales and profitability
include the number of stores in operation and their relative maturities, new
store openings, location of stores and customer demographics, merchandise
selection, new product acceptance, competition and effectiveness of current
marketing techniques.
Management believes that most new stores will attain mature store sales levels
within nine months after commencing operations and thereafter may experience
only modest year to year sales growth. No assurance can be given, however, that
new stores will achieve or that mature stores will sustain, desired operating
results and profitability. There can be no assurance of maintaining sales and
profitability at the levels achieved during fiscal 1997.
RESULTS OF OPERATIONS
The following table sets forth certain items in the statements of operations
expressed as (i) percentages of net sales for the years indicated and (ii)
percentage changes from the prior year:
PERCENTAGE
YEAR ENDED INCREASE/(DECREASE)
------------------------------------ -----------------------
MARCH 30, MARCH 31, APRIL 2, 1997 OVER 1996 OVER
1997 1996 1995 1996 1995
--------- --------- -------- --------- ---------
Net sales 100.0% 100.0% 100.0% 48.1% 1.3%
Cost of sales 63.1 58.6 61.1 59.6 (2.8)
--------- --------- --------
Gross profit 36.9 41.4 38.9 31.9 7.7
Operating expenses 23.4 31.5 30.9 10.3 3.2
General and administrative expenses 7.1 9.2 9.7 14.2 (3.3)
--------- --------- --------
Operating income (loss) 6.3 0.7 (1.7) NA NA
Interest expense - (0.1) (0.1) (55.7) (9.1)
Interest income 0.2 0.2 0.2 68.3 (5.4)
Income tax provision 2.0 0.5 - NA NA
--------- --------- --------
Net income (loss) 4.4% 0.3% (1.6)% NA NA
========= ========= ========
COMPARISON OF FISCAL 1997 TO FISCAL 1996
The Company derived approximately 97% of its fiscal 1997 net sales from retail
operations. The balance of net sales was attributable to the publication of GAME
INFORMER magazine. Net sales increased from $81,382,000 in fiscal 1996 to
$120,555,000 during fiscal 1997, an increase of 48.1%. The Company operated 188
stores at the end of fiscal 1997 compared to 173 stores at the end of fiscal
1996. During fiscal 1997 the Company opened 19 new stores while closing 4
locations. Comparable store sales for fiscal 1997 increased 50%. The Company
attributes the strong sales increase to a revitalization of the video game
category primarily due to growing market penetration of Sony PlayStation,
Nintendo 64 and Sega Saturn products.
Cost of sales increased from $47,690,000 in fiscal 1996 to $76,119,000 during
fiscal 1997, an increase of 59.6%. The dollar increase in cost of sales is
primarily due to the strong growth in sales. Cost of sales as a percentage of
net sales increased from 58.6% in 1996 to 63.1% in 1997. This increase occurred
primarily as sales mix for fiscal 1997 reflected proportionately higher sales of
next generation products, which are currently sold at higher cost percentages
than that of earlier generation product offerings.
Operating expenses increased from $25,624,000 in fiscal 1996 to $28,261,000 in
fiscal 1997, an increase of 10.3%. This increase is primarily due to higher
store payroll expense related to the increased sales volume compared to prior
year. Operating expenses as a percentage of net sales decreased from 31.5% in
1996 to 23.4% in 1997, the result of improved sales leveraging.
General and administrative expenses increased from $7,521,000 in fiscal 1996 to
$8,592,000 in fiscal 1997, an increase of 14.2%. The dollar increase is
primarily due to increased payroll. General and administrative expenses
decreased as a percentage of net sales from 9.2% in 1996 to 7.1% in 1997, the
result of improved sales leveraging.
The Company generated operating income of $7,583,000 in fiscal 1997 compared to
$547,000 in fiscal 1996.
Interest expense decreased from $70,000 in fiscal 1996 to $31,000 in fiscal
1997, a decrease of 55.7%, as the Company significantly reduced borrowings on
its line of credit compared to prior year.
Interest income increased from $123,000 in fiscal 1996 to $207,000 in fiscal
1997, an increase of 68.3%, as the Company maintained significantly higher
levels of cash and cash equivalents through most of fiscal 1997 as compared to
fiscal 1996.
The Company recorded an income tax provision of $2,409,000 in fiscal 1997
compared to $395,000 in fiscal 1996, as the Company generated net income before
taxes of $7,759,000 in fiscal 1997 compared to $600,000 in fiscal 1996. The
Company's income tax rate declined from 66% in fiscal 1996 to 31% in fiscal 1997
primarily as net deferred tax assets increased due to elimination of the
valuation allowance.
As a result of the above factors, the Company generated net income of
$5,350,000, or $0.86 per share in fiscal 1997 compared to $205,000, or $0.03 per
share in fiscal 1996.
COMPARISON OF FISCAL 1996 TO FISCAL 1995
The Company derived approximately 97% of its fiscal 1996 net sales from retail
operations. The balance of net sales was attributable to the publication of GAME
INFORMER magazine. Net sales increased from $80,365,000 in fiscal 1995, to
$81,382,000 during fiscal 1996, an increase of 1.3%. The growth in net sales
occurred primarily as a result of operating a greater number of stores through
most of fiscal 1996 as compared to fiscal 1995, and increased mail order sales.
The Company began fiscal 1996 with 182 stores and ended with 173, compared to
fiscal 1995 which began with 110 stores and ended with 182 stores. During fiscal
1996 the Company opened 7 new locations while closing 16 lower performing
stores. Comparable store sales decreased 12% from fiscal 1995, impacted by the
continuing transition in the video game industry, as the market shifted from
mature 16-bit technology to advanced next generation systems. These new systems
included Sony PlayStation and Sega Saturn which were released in calendar 1995,
and Nintendo 64 which was released in calendar 1996. Revenues generated from
these advanced systems and software did not fully offset revenue declines of
16-bit product.
Cost of sales decreased from $49,080,000 in fiscal 1995 to $47,690,000 during
fiscal 1996, a decrease of 2.8%. This decrease primarily occurred as it was not
necessary for the Company to repeat the price discounting and markdowns which
had been required to generate holiday sales and move inventory during late
fiscal 1995. Cost of sales as a percentage of net sales favorably decreased from
61.1% to 58.6% primarily as the Company generated a greater proportion of sales
from previously played product categories, which have lower cost percentages
than that of new product categories.
Operating expenses increased from $24,837,000 in fiscal 1995 to $25,624,000 in
fiscal 1996, an increase of 3.2%. This increase was primarily attributable to
operating a greater number of stores through most of fiscal 1996. The Company
began fiscal 1996 with 182 stores and ended with 173, while in fiscal 1995 began
with 110 stores and ended with 182 stores. Operating expenses as a percentage of
net sales increased from 30.9% to 31.5%, primarily reflecting the additional
costs of operating a greater number of stores through most of fiscal 1996 while,
at the same time, experiencing lower sales per store.
General and administrative expenses decreased from $7,776,000 in fiscal 1995 to
$7,521,000 in fiscal 1996, a reduction of 3.3%, and also decreased as a
percentage of net sales from 9.7% to 9.2%. The dollar decrease in general and
administrative expenses was primarily attributable to savings in payroll expense
as a result of reduced staffing levels.
The Company generated operating income of $547,000 in fiscal 1996 compared to an
operating loss of $1,328,000 in fiscal 1995.
Interest income decreased from $130,000 in fiscal 1995 to $123,000 in fiscal
1996, due to the Company's lower cash position through most of fiscal 1996 as
compared to fiscal 1995.
The Company reported an income tax provision of $395,000 in fiscal 1996 compared
to no tax provision in fiscal 1995, which had an operating loss.
As a result of the above factors, the Company generated net income of $205,000,
or $0.03 per share in fiscal 1996 compared to a net loss of $1,275,000, or $0.22
per share in fiscal 1995.
SEASONALITY AND QUARTERLY RESULTS
The Company's business is seasonal with a majority of net sales generated in the
third and fourth quarters, which include the holiday selling season. For the 169
stores operating the full 12 months in fiscal 1997, 33% of net sales occurred in
the first half of the year with 67% in the second half of the year. Accordingly,
annual profitability is heavily dependent on third and fourth quarter net sales.
In addition to sales seasonality, the Company's quarterly results are also
affected by the number and timing of new store openings. Growth of the store
base may obscure the impact of seasonal influences. Because of the seasonality
of the Company's business and factors mentioned above, results for any one
quarter are not necessarily indicative of the results that may be achieved for a
full fiscal year.
Net sales, gross profit and operating income (loss) for the past eight fiscal
quarters, together with the number of stores open at the end of each quarter,
are presented in the following table:
(IN THOUSANDS, EXCEPT NUMBER OF STORES)
FISCAL 1997 FISCAL 1996
------------------------------------------- -------------------------------------------
1ST 2ND 3RD 4TH 1ST 2ND 3RD 4TH
QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER
------- ------- ------- ------- ------- ------- ------- -------
Net sales $18,862 $20,415 $46,461 $34,817 $12,261 $15,335 $31,897 $21,889
Gross profit 6,850 7,872 16,366 13,348 5,348 6,503 12,558 9,283
Operating income (loss) (516) 32 4,508 3,559 (1,945) (919) 1,686 1,725
Stores open at quarter end 173 176 188 188 181 178 182 173
Although the results presented above may not be indicative of future trends or
performance, the Company anticipates that quarterly net sales and operating
income (loss) will continue to be significantly impacted by seasonality
patterns.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary ongoing financing requirements are for new store expansion
and inventory. During fiscal 1997, 1996 and 1995, the Company had net cash
provided by (used in) operating activities of $3,451,000, $5,043,000 and
$(1,111,000), respectively. During fiscal 1997, the operating activities which
most significantly impacted cash were net income, offset by an increase in
inventory and a decrease in accounts payable.
In fiscal 1997, the Company sold 85,000 shares of common stock through the
exercise of warrants held by underwriters of the Company's initial public
offering at a price of $6.00 per share, generating net proceeds of $510,000. In
fiscal 1997, the Company sold 94,405 shares of stock through the exercise of
stock options at prices ranging from $1.33 to $14.39 per share, generating net
proceeds, including tax benefits, of $387,000.
The Company invested $1,548,000 in capital expenditures in fiscal 1997 primarily
for new store openings and other store related expenditures. During fiscal 1998,
the Company plans to incur capital expenditures of approximately $4,000,000 for
new store openings, other store expenditures, enhancements to corporate
information systems and general corporate purposes.
The Company currently has a $3,000,000 revolving credit facility, seasonally
increasing to $10,000,000 with a commercial bank. The interest rate on
outstanding borrowings under the facility (8-3/4 % at March 30, 1997) is equal
to the bank's prime rate plus one quarter of one percent. An amendment to this
credit facility is currently being finalized which will lower the interest rate
to the bank's prime rate. Additionally, the credit facility will be unsecured
under terms of the amended agreement. The facility requires the Company to
maintain certain financial ratios and achieve certain operating results. There
were no balances under this facility at March 30, 1997 or March 31, 1996.
The Company believes that cash from operations and funds available under its
revolving credit facility will provide sufficient funds for financing planned
store openings, working capital needs and capital expenditures for at least 12
months.
FORWARD LOOKING STATEMENTS
Statements contained above with respect to future sales prospects and expansion
plans are forward looking statements, and are subject to uncertainties from
factors including growth of the industry, the competitive environment, success
of the Company's existing operations, availability of new store sites and the
Company's ability to finance new store expansion.
Future financial performance greatly depends upon the Company's ability to
effectively manage a base of profitable stores. The Company plans further
significant expansion and believes that the addition of new stores will continue
to be a primary component of the Company's growth. The Company's ability to open
and operate new stores profitably will depend upon a number of factors
including, but not limited to, availability of suitable locations; negotiation
of acceptable lease terms; ability to attract, train and retain qualified
personnel and the ability to control other operational aspects of the Company's
growth. Additionally, the failure to maintain or upgrade financial and
management control systems or to respond effectively to difficulties encountered
during expansion could materially adversely affect the Company's financial and
operating results. Although the Company believes that it has effectively managed
its growth in the past, there can be no assurance that the Company will
successfully continue its planned expansion, or that new stores will perform as
anticipated.
The ability of the Company to expand and operate stores profitably can also be
dependent upon the ability of the Company to obtain requisite financing. There
can be no assurance that such financing will be available to the Company at
terms acceptable to the Company, or at any terms. The ability of the Company to
obtain any future financing through additional issuance of stock to the public
would be highly dependent upon the market price for the Company's securities.
The market price for shares of the Common Stock may be highly volatile depending
on various factors such as the general economy; stock market conditions;
announcements by the Company, its vendors or competitors; announcements of
technological innovations or products that may affect the Company's business;
fluctuations in the Company's operating results and performance of the Company
compared to market expectations.
The interactive entertainment retailing business is highly competitive. As the
Company offers both previously played and new product, it competes with other
companies in the market for previously played product and with retailers of new
interactive entertainment, many of which are large nationally recognized retail
chains. (See Item 1. Business -- Competition.) There can be no assurance that
the Company can continue to successfully compete in the sale of either new or
previously played product. In addition, new distribution channels for
interactive entertainment, including on-line services and other alternate
delivery systems, may adversely impact future sales of product through retail
stores such as the Company's.
Although the Company attempts to maintain product mix and inventory levels which
satisfy consumer demand, there can be no assurance that it will be successful in
anticipating and responding to changing consumer preferences. The ability to
operate with the proper merchandise assortment is important to the Company's
future financial performance. Overstocked, understocked or unbalanced
inventories can occur due to factors including misjudgements by the Company in
assessing product demand or establishing prices, vendor allocations, logistical
difficulties and potential limitations of the Company's management information
systems.
The interactive entertainment industry periodically undergoes technological
advances and developments. Introduction of new hardware systems, or the
anticipated introduction of such developments, may affect consumer demand for
existing games, hardware and accessories. Further, new games must continually be
developed for the new hardware. Neither the development of new hardware or games
nor the timing of release of new products is within the control of the Company.
The continued successful release of new interactive entertainment product that
is accepted by consumers is important to the Company's business, both for
increasing sales and for encouraging consumers to visit the stores to buy and
sell product. Changes in hardware systems may impact the Company's business both
for previously played product and for new product as consumers determine whether
to move to new systems or to continue purchasing games for existing systems.
Also, delays in the introduction of new product may affect consumer interest in
the overall interactive entertainment product category.
OTHER MATTERS
The Company does not believe that its business has been significantly impacted
by inflation.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial statements required by this item can be found beginning on page 15 of
this Form 10-K and are deemed incorporated herein by reference.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item 10 regarding directors is incorporated by
reference from the Proxy Statement sections entitled "Election of Directors,"
"Other Executive Officers" and "Section 16(a) Beneficial Ownership Reporting
Compliance."
ITEM 11.
EXECUTIVE COMPENSATION
The information required by this Item 11 is incorporated by reference from the
Proxy Statement sections entitled "Directors' Compensation," "Executive
Compensation," "Options Granted During Fiscal 1997," "Aggregate Option Exercises
During Fiscal 1997 and Fiscal Year-End Option Values."
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item 12 is incorporated by reference from the
Proxy Statement section entitled "Ownership of Common Stock."
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
None.
ITEM 14.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Financial Statements
The financial statements filed as part of this Annual Report on Form
10-K are described in the Index to Consolidated Financial Statements
and Schedule on page 15.
(b) Reports on Form 8-K
No reports on Form 8-K were filed during the last quarter of the
period covered by this report.
(c) Exhibits
EXHIBIT
NUMBER DESCRIPTION
3.1 Articles of Incorporation, as amended and restated to date
(Note 1)
3.2 Bylaws, as amended and restated to date (Note 1)
10.1a Credit Agreement effective June 20, 1995 by and between the
Registrant and Marquette Capital Bank, including Revolving Credit
Note and Security Agreement (Note 2)
10.1b Amendment to Credit Agreement dated June 30, 1996 (Note 3)
10.2 Form of warrant issued in May 1992 (Note 1)
*10.3 Stock Option Plan for Nonemployee Directors (Note 1)
*10.4 Employee Incentive Stock Option Plan (Note 1)
*10.5a 1993 Stock Option Plan (Note 4)
*10.5b Form of agreement for nonqualified option granted under 1993 Plan
(Note 5)
*10.5c Amendment to 1993 Stock Option Plan approved by Shareholders on
August 5, 1994 (Note 6)
*10.5d Amendment to 1993 Stock Option Plan (Note 7)
10.7a Lease for corporate headquarters in Eden Prairie, Minnesota
(Note 8)
10.7b Amendment to lease for corporate headquarters in Eden Prairie,
Minnesota
10.8 Warrant to Andcor Co., Inc. (Note 4)
11 Statement Re: Computation of Per Share Earnings (See page 29
hereof.)
23 Consent of Independent Auditors
27 Financial Data Schedule
Note 1. Filed as an exhibit to Registration Statement on Form S-18 (SEC
No. 33-49102C) ("Form S-18"), filed on June 30, 1992, and
incorporated herein by reference.
Note 2. Filed as an exhibit to Form 10-K for fiscal year 1995, filed on
July 3, 1995, and incorporated herein by reference.
Note 3. Filed as an exhibit to Form 10-Q for first quarter fiscal 1997,
filed on August 20, 1996, and incorporated herein by reference.
Note 4. Filed as an exhibit to Form S-1, filed on June 3, 1993, and
incorporated herein by reference.
Note 5. Filed as an exhibit to Amendment No. 1 to Registration Statement
on Form S-1 (SEC No. 33-63782) ("Form S-1"), filed on June 21,
1993, and incorporated herein by reference.
Note 6. Filed as an exhibit to Form 10-K for fiscal year 1994, filed on
July 6, 1994, and incorporated herein by reference.
Note 7. Filed as an exhibit to Form 10-K for fiscal year 1996, filed on
June 28, 1996, and incorporated herein by reference.
Note 8. Filed as an exhibit to Amendment No. 1 to Form S-18, filed on July
27, 1992, and incorporated herein by reference.
* Denotes management contract or compensation plan required to be
filed as an exhibit to this form.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, hereunto duly authorized.
FUNCO, INC.
by: /S/ DAVID R. POMIJE
David R. Pomije
Chairman of the Board of Directors
and Chief Executive Officer
In accordance with the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the Registrant, and in the
capacities indicated, on June 26, 1997.
NAME TITLE
- - ---- -----
/s/ DAVID R. POMIJE Chairman of the Board of Directors and
David R. Pomije Chief Executive Officer
/s/ ROBERT M. HIBEN Chief Financial Officer and Secretary
Robert M. Hiben
/s/ STANLEY A. BODINE Director
Stanley A. Bodine
/s/ RICHARD T. GUIDERA Director
Richard T. Guidera
/s/ GEORGE E. MILEUSNIC Director
George E. Mileusnic
/s/ PATRICK J. FERRELL Director
Patrick J. Ferrell
FUNCO, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE
PAGE
CONSOLIDATED FINANCIAL STATEMENTS:
Report of Management 16
Report of Ernst & Young LLP, Independent Auditors 17
Consolidated Statements of Operations for the fiscal years ended March
30, 1997, March 31, 1996 and April 2, 1995 18
Consolidated Balance Sheets as of March 30, 1997 and March 31, 1996 19
Consolidated Statements of Cash Flows for the fiscal years ended March
30, 1997, March 31, 1996 and April 2, 1995 20
Consolidated Statements of Shareholders' Equity for the fiscal years
ended March 30, 1997, March 31, 1996 and April 2, 1995 21
Notes to Consolidated Financial Statements 22-27
SCHEDULE:
Schedule II -- Valuation and Qualifying Accounts 28
REPORT OF MANAGEMENT
The management of Funco, Inc. is responsible for the preparation, integrity and
objectivity of the accompanying consolidated financial statements. The
consolidated financial statements have been prepared in accordance with
generally accepted accounting principles and include amounts which are based
upon estimates and informed judgments of management.
In fulfilling its responsibility for the integrity of financial information,
management has established a system of internal controls which provides
reasonable assurance that transactions are executed in accordance with
management's intention and authorization, that assets are properly safeguarded
and accounted for, and that financial statements are prepared in accordance with
generally accepted accounting principles. The concept of reasonable assurance is
based on the recognition that there are inherent limitations in all systems of
internal control, and that the cost of such systems should not exceed the
benefits derived. These systems are periodically reviewed and modified in
response to changing conditions.
The management of Funco, Inc. also recognizes its responsibility for fostering a
strong ethical climate so that the Company's affairs are conducted according to
the highest standards of personal and business conduct.
The adequacy of the Company's internal accounting controls, accounting
principles employed, scope of audit work and quality of financial reporting are
reviewed by the Audit Committee of the Board of Directors, consisting solely of
outside directors. The independent auditors meet with and have confidential
access to the Audit Committee to discuss auditing and financial reporting issues
with or without management present.
REPORT OF INDEPENDENT AUDITORS
Board of Directors and Shareholders
Funco, Inc.
We have audited the accompanying consolidated balance sheets of Funco, Inc. as
of March 30, 1997 and March 31, 1996, and the related consolidated statements of
operations, shareholders' equity and cash flows for each of the three years in
the period ended March 30, 1997. Our audit also included the financial statement
schedule listed in Item 14(a). These consolidated financial statements and
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these consolidated financial statements and schedule
based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. 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 financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Funco, Inc. at
March 30, 1997 and March 31, 1996 and the consolidated results of its operations
and its cash flows for each of the three years in the period ended March 30,
1997, in conformity with generally accepted accounting principles. Also, in our
opinion, the related financial statement schedule, when considered in relation
to the basic financial statements taken as a whole, presents fairly, in all
material respects, the information set forth therein.
/s/ ERNST & YOUNG LLP
Minneapolis, Minnesota
May 12, 1997
FUNCO, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
YEAR ENDED
-----------------------------------------
MARCH 30, MARCH 31, APRIL 2,
1997 1996 1995
----------- ----------- -----------
Net sales $ 120,555 $ 81,382 $ 80,365
Cost of sales 76,119 47,690 49,080
----------- ----------- -----------
Gross profit 44,436 33,692 31,285
Operating expenses 28,261 25,624 24,837
General and administrative expenses 8,592 7,521 7,776
----------- ----------- -----------
Operating income (loss) 7,583 547 (1,328)
Interest expense (31) (70) (77)
Interest income 207 123 130
----------- ----------- -----------
Net income (loss) before income taxes 7,759 600 (1,275)
Income tax provision 2,409 395 -
----------- ----------- -----------
Net income (loss) $ 5,350 $ 205 $ (1,275)
=========== =========== ===========
Net income (loss) per share $ 0.86 $ 0.03 $ (0.22)
Weighted average number of common
and common equivalent shares 6,197,383 5,971,194 5,786,719
SEE ACCOMPANYING NOTES.
FUNCO, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
MARCH 30, MARCH 31,
1997 1996
------- -------
ASSETS
Current Assets
Cash and cash equivalents $ 8,408 $ 5,783
Accounts receivable 1,094 621
Inventories 13,831 9,775
Prepaid expenses 782 1,116
Current deferred tax asset 532 552
------- -------
Total current assets 24,647 17,847
Net property and equipment 5,954 7,662
Long-term deferred tax asset 984 -
Other assets 160 159
------- -------
Total assets $31,745 $25,668
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities
Accounts payable $ 1,387 $ 3,195
Accrued liabilities 5,182 3,634
Current portion of capital lease obligations 20 31
Deferred revenue 747 622
------- -------
Total current liabilities 7,336 7,482
Capital lease obligations, less current portion - 3
Accrued rent 91 112
Shareholders' Equity
Common stock (issued and outstanding for 1997 and
1996, respectively: 6,056,788 and 5,877,887) 61 59
Additional paid-in capital 18,698 17,803
Retained earnings 5,559 209
------- -------
Total shareholders' equity 24,318 18,071
------- -------
Total liabilities and shareholders' equity $31,745 $25,668
======= =======
SEE ACCOMPANYING NOTES.
FUNCO, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEAR ENDED
-----------------------------
MARCH 30, MARCH 31, APRIL 2,
1997 1996 1995
------- ------- -------
Operating Activities
Net income (loss) $ 5,350 $ 205 $(1,275)
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Depreciation and amortization 3,283 3,719 2,776
Deferred tax asset (964) (198) (206)
Net loss on disposal of property and equipment 133 227 -
Loss on investment in marketable securities - - 78
Changes in operating assets and liabilities:
Accounts receivable (473) 112 (346)
Inventories (4,056) (1,438) (1,895)
Prepaid expenses 334 (87) 15
Accounts payable (1,808) 1,832 (591)
Accrued liabilities 1,527 596 336
Deferred revenue 125 75 (3)
------- ------- -------
Net cash provided by (used in) operating
activities 3,451 5,043 (1,111)
Investing Activities
Additions to property and equipment (1,548) (444) (7,233)
Increase in other assets (98) (60) (32)
Proceeds from sales of property and equipment 3 6 -
Investment and dividend reinvestment in marketable
securities - - (46)
Proceeds from sales of marketable securities - - 6,992
------- ------- -------
Net cash used in investing activities (1,643) (498) (319)
Financing Activities
Payments of obligations under capital leases (80) (299) (432)
Net proceeds from issuance of common stock 897 66 407
Payments of long-term debt - - (4)
------- ------- -------
Net cash provided by (used in) financing
activities 817 (233) (29)
------- ------- -------
Increase (decrease) in cash and cash equivalents 2,625 4,312 (1,459)
Cash and cash equivalents at beginning of year 5,783 1,471 2,930
------- ------- -------
Cash and cash equivalents at end of year $ 8,408 $ 5,783 $ 1,471
======= ======= =======
SEE ACCOMPANYING NOTES.
FUNCO, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(IN THOUSANDS)
TOTAL
COMMON STOCK ADDITIONAL SHARE-
----------------- PAID-IN RETAINED HOLDERS'
SHARES AMOUNT CAPITAL EARNINGS EQUITY
------ ------ ------- -------- ------
Balance at April 3, 1994 5,736 $ 57 $17,332 $ 1,264 $18,653
Common stock issued, net of costs 93 1 314 315
Tax benefits of stock options 92 92
Change in unrealized loss on
securities, net of tax 15 15
Net loss (1,275) (1,275)
----- ----- ------- ------- -------
Balance at April 2, 1995 5,829 58 17,738 4 17,800
Common stock issued, net of costs 49 1 65 66
Net income 205 205
----- ----- ------- ------- -------
Balance at March 31, 1996 5,878 59 17,803 209 18,071
----- ----- ------- ------- -------
Common stock issued, net of costs 179 2 799 801
Tax benefits of stock options 96 96
Net income 5,350 5,350
----- ----- ------- ------- -------
Balance at March 30, 1997 6,057 $ 61 $18,698 $ 5,559 $24,318
===== ===== ======= ======= =======
SEE ACCOMPANYING NOTES.
FUNCO, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 30, 1997
1. SIGNIFICANT ACCOUNTING POLICIES
NATURE OF BUSINESS -- Funco, Inc. is engaged in the business of providing
interactive home entertainment primarily through the purchase and resale of new
and previously played video games and related hardware and accessory items
through its FUNCOLAND stores and mail order operation. It also publishes a video
game magazine, GAME INFORMER. The Company was incorporated in Minnesota in March
1988.
PRINCIPLES OF CONSOLIDATION -- The consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiary. All intercompany
accounts and transactions have been eliminated.
REVENUE RECOGNITION -- Revenue from retail sales of the Company's products is
recognized at the time of sale. Deferred revenue represents amounts received for
subscriptions to a specified number of future video game magazine issues.
Subscription revenue is recognized on a straight-line basis as the magazine
issues are delivered.
ADVERTISING COSTS -- Advertising costs, included in operating expenses, are
expensed as incurred and were $2,898,000, $2,361,000 and $3,789,000 for the
years 1997, 1996 and 1995, respectively.
FISCAL YEAR -- The Company's fiscal year ends on a Sunday on or near March 31.
The fiscal years ended March 30, 1997, March 31, 1996 and April 2, 1995
consisted of 52 weeks each. Unless otherwise stated, references to years in this
report relate to fiscal years rather than calendar years.
CASH EQUIVALENTS -- Cash equivalents represent short-term investments with a
maturity of three months or less at the time of purchase. Short-term investments
are recorded at cost, which approximates market.
MARKETABLE SECURITIES -- Marketable securities are carried at fair value, with
any unrealized gains and losses, net of tax, reported as a separate component of
shareholders' equity. Realized gains and losses and declines in value judged to
be other-than-temporary on marketable securities are included in interest
income.
INVENTORIES -- Inventories consist of new and previously played video games,
hardware and accessories and are valued at the lower of cost, determined using
the first-in, first-out (FIFO) method, or market.
PROPERTY AND EQUIPMENT -- Property and equipment are recorded at cost. The
Company uses the straight-line method of computing depreciation based on the
assets' estimated useful lives, which range from 3 to 5 years or the term of the
respective lease.
IMPAIRMENT OF LONG-LIVED ASSETS -- The Company records impairment losses on
long-lived assets used in operations when indicators of impairment are present
and the undiscounted cash flows estimated to be generated by those assets are
less than the assets' carrying amounts.
OTHER ASSETS -- Included in other assets are costs incurred in leasing and
developing new locations and other intangible assets which the Company has
capitalized and is amortizing over periods ranging from one to five years.
Accumulated amortization was $86,000 at March 30, 1997 and $70,000 at March 31,
1996.
STOCK OPTIONS -- The Company has elected to recognize compensation cost for its
stock based compensation plans in accordance with Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees". Accordingly, no
compensation expense is recognized for stock options with exercise prices equal
to, or in excess of, the market value of the underlying shares of stock at the
date of grant. In fiscal 1997, the Company adopted the disclosure-only
provisions of Statement of Financial Accounting Standards No. 123 (SFAS No.
123), "Accounting for Stock-Based Compensation".
NET INCOME (LOSS) PER SHARE -- Net income (loss) per share is based on the
weighted average number of common and dilutive common equivalent shares
outstanding during the period.
USE OF ESTIMATES -- Preparing financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect reporting amounts in the financial statements and
accompanying notes. Actual results could differ from these estimates.
2. FINANCING ARRANGEMENTS
The Company currently has a $3,000,000 revolving credit facility, seasonally
increasing to $10,000,000 with a commercial bank. The interest rate on
outstanding borrowings under the facility (8-3/4 % at March 30, 1997) is equal
to the bank's prime rate plus one quarter of one percent. An amendment to this
credit facility is currently being finalized which will lower the interest rate
to the bank's prime rate. Additionally, the credit facility will be unsecured
under terms of the amended agreement. The facility requires the Company to
maintain certain financial ratios and achieve certain operating results. There
were no balances under this facility at March 30, 1997 or March 31, 1996.
3. LEASES
CAPITAL LEASES -- The Company has leased equipment under sale/leaseback and
lease financing arrangements. Under the Company's sale/leaseback transactions,
equipment has generally been sold at net book value with no gain or loss
recorded. The equipment capitalized under these arrangements and included in
property and equipment is as follows:
(IN THOUSANDS) 1997 1996
----- -----
Equipment $ 696 $ 649
Accumulated amortization (669) (587)
----- -----
$ 27 $ 62
===== =====
Amortization of leased assets is included in depreciation and amortization
expense.
Equipment at a cost of $66,000, $33,000 and $0 was acquired in exchange for
obligations under capital leases in the years 1997, 1996 and 1995, respectively.
The remaining future minimum payments are $20,000 payable in 1998.
Total interest paid, including interest on short-term borrowings and capital
leases, was $31,000, $70,000 and $77,000 for the years 1997, 1996 and 1995,
respectively.
OPERATING LEASES -- The Company has rental commitments for office space, retail
space and office equipment under non-cancelable operating leases. Most of these
leases contain provisions for renewal options and require the Company to pay
other lease related costs.
Future minimum lease payments under non-cancelable operating leases consist of
the following:
(IN THOUSANDS)
1998 $3,950
1999 2,440
2000 1,181
2001 71
2002 50
------
$7,692
======
Rent expense was $4,974,000, $4,677,000 and $4,137,000 for the years 1997, 1996
and 1995, respectively.
4. NET PROPERTY AND EQUIPMENT CONSIST OF THE FOLLOWING:
(IN THOUSANDS) 1997 1996
-------- -------
Furniture and fixtures $ 4,273 $ 3,760
Equipment 6,634 6,306
Leasehold improvements 5,627 5,295
Other 64 64
-------- -------
16,598 15,425
Less accumulated depreciation (10,644) (7,763)
-------- -------
Net property and equipment $ 5,954 $ 7,662
======== =======
5. ACCRUED LIABILITIES CONSIST OF THE FOLLOWING:
(IN THOUSANDS) 1997 1996
------ ------
Purchase credit memos payable $1,731 $1,408
Employee compensation and related taxes 1,251 855
Sales tax payable 529 337
Income tax payable 875 510
Other accrued liabilities 796 524
------ ------
Total accrued liabilities $5,182 $3,634
====== ======
6. STOCK OPTIONS AND WARRANTS
Under the terms of the Company's various stock option plans, a maximum of
1,150,000 shares of common stock may be reserved for issuance to directors,
officers and employees, upon the exercise of stock options. Additionally each
year, on May 1st, the Company reserves an additional 1% of the total number of
Common Stock shares outstanding at fiscal year end. Subsequent to March 30,
1997, the Company has reserved an additional 60,568 shares for use in its stock
option plan. The stock options are exercisable over periods up to ten years from
date of grant and include incentive stock options and non-qualified stock
options.
At March 30, 1997 there were 799,633 options outstanding of which 335,120 were
exercisable. A summary of stock option activity for the last three years is as
follows:
WEIGHTED
AVERAGE
EXERCISE PRICE
SHARES PER SHARE
------- ------
Outstanding April 3, 1994 510,529 $ 6.21
Granted 228,479 14.47
Exercised 47,333 1.98
Canceled 108,134 13.23
------- ------
Outstanding April 2, 1995 583,541 8.49
Granted 301,118 4.31
Exercised 49,100 1.33
Canceled 169,050 11.93
------- ------
Outstanding March 31, 1996 666,509 6.25
Granted 286,501 8.03
Exercised 94,405 3.13
Canceled 58,972 7.61
------- ------
Outstanding March 30, 1997 799,633 7.16
======= ======
Exercisable March 30, 1997 335,120 $ 7.13
======= ======
The following table summarizes information concerning outstanding and
exercisable options:
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
RANGE OF REMAINING AVERAGE AVERAGE
EXERCISE NUMBER CONTRACTURAL EXERCISE NUMBER EXERCISE
PRICES OUTSTANDING LIFE (YEARS) PRICE EXERCISABLE PRICE
--------- ----------- ------------ ------- ----------- ------
$ 0 - $ 4 133,174 6.24 $ 2.09 100,408 $ 1.67
$ 4 - $ 8 338,261 7.61 5.66 105,206 5.49
$ 8 - $12 240,521 7.81 9.38 68,221 11.00
$12 - $16 87,677 5.96 14.55 61,285 14.56
--------- ----------- ------------ ------- ----------- ------
$ 0 - $16 799,633 7.26 $ 7.16 335,120 $ 7.13
========= =========== ============ ======= =========== ======
Pursuant to the initial public offering of the Company's stock, a warrant to
purchase 100,000 shares of its common stock at $6.00 per share was issued to the
underwriter of the offering and subsequently transferred to certain principals.
These warrants were fully exercised over four years commencing August 1993. In
fiscal 1997, the Company sold 85,000 shares of common stock through the exercise
of these warrants, generating net proceeds of $510,000.
As part of a private placement of promissory notes in May 1992, the Company
issued warrants to purchase 30,000 shares of its common stock at $5.00 per share
to several investors. The warrants were exercisable for a period of four years,
commencing May 1993. All such warrants have been exercised. In April 1993, the
Company granted to a consultant a five year warrant to purchase 7,000 shares of
common stock at $12.75 per share. The warrant is exercisable for a period of 5
years commencing June 1, 1993. The Company has reserved 7,000 shares for the
exercise of warrants.
In fiscal 1997, the Company sold 94,405 shares of stock through the exercise of
stock options at prices ranging from $1.33 to $14.39 per share, generating net
proceeds, including tax benefits, of $387,000.
In fiscal 1997, the Company adopted the disclosure-only provisions of Statement
of Financial Accounting Standards No. 123 (SFAS No. 123), "Accounting for
Stock-Based Compensation." The Company has elected to continue to account for
stock based compensation plans in accordance with Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees," making pro forma
disclosures of net earnings and earnings per share as if the fair value-based
method had been applied. Accordingly, no compensation expense is recognized for
stock options with exercise prices equal to, or in excess of, the market value
of the underlying shares of stock at the date of grant. Had compensation expense
for the Company's stock option awards been determined based upon grant date fair
value consistent with the methodology prescribed under SFAS No. 123, the
Company's net income and earnings per share would have been $5,854,000, or $0.82
per share and $87,000, or $0.01 per share for the years 1997 and 1996,
respectively.
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted average
assumptions.
1997 1996
------- -------
Expected volatility 74.40% 74.40%
Risk-free interest rate 6.00% 6.00%
Expected dividend yield 0.0% 0.0%
Expected life of options 3 Years 3 Years
The pro forma effect on net income and earnings per share is not representative
of the pro forma net earnings in future years as it does not take into
consideration pro forma compensation expense related to grants made prior to
fiscal 1996.
The weighted average fair value for options granted during years 1997 and 1996
is $4.14 and $2.24 per share, respectively.
7. INCOME TAXES
Significant components of the provision for income taxes for the years 1997 and
1996 are as follows:
(IN THOUSANDS) 1997 1996
------ -----
Current
Federal $2,749 $ 392
State 624 201
------ -----
3,373 593
Deferred
Federal (786) (160)
State (178) (38)
------ -----
(964) (198)
------ -----
$2,409 $ 395
====== =====
Deferred income taxes are due to temporary differences between carrying values
of certain assets and liabilities for financial reporting and income tax
purposes. Significant components of deferred taxes at March 30, 1997 and March
31, 1996, are as follows:
(IN THOUSANDS) 1997 1996
------ ------
Accrued rent $ 66 $ 129
Inventories 419 233
Depreciation 1,107 554
Alternative minimum tax - 261
Other (76) 19
------ ------
Net deferred tax assets before valuation allowance 1,516 1,196
Valuation allowance for net deferred tax asset - (644)
------ ------
Net deferred tax asset $1,516 $ 552
====== ======
The recognized deferred tax asset is based upon expected reversal of certain
temporary differences. Income taxes of $2,890,000, $66,000, and $666,000 were
paid in the years 1997, 1996 and 1995, respectively.
Reconciliation of the Company's tax rate is as follows:
(IN THOUSANDS) 1997 1996
------ -----
Expected tax expense $2,638 $ 204
State income tax, net of federal
benefit 294 133
Change in valuation allowance (644) 11
Alternative minimum tax expense - 18
Other 121 29
------ -----
$2,409 $ 395
====== =====
Effective tax rate 31% 66%
====== =====
FUNCO, INC.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
COL. A COL. B COL. C COL. D COL. E
ADDITIONS DEDUCTIONS
------------ ----------
BALANCE CHARGED TO BALANCE
AT BEGINNING COSTS AT END
DESCRIPTION OF PERIOD AND EXPENSES DESCRIBE OF PERIOD
----------- --------- ------------ -------- ---------
Year ended March 30, 1997:
Deducted from asset accounts
Allowance for doubtful accounts $ 17 $ 25 $ 2(1) $ 40
Inventory reserve 402 222 - 624
---- ---- ---- ----
Total $419 $247 $ 2 $664
==== ==== ==== ====
Year ended March 31, 1996:
Deducted from asset accounts
Allowance for doubtful accounts $ 14 $ 10 $ 7(1) $ 17
Inventory reserve 478 186 262(2) 402
---- ---- ---- ----
Total $492 $196 $269 $419
==== ==== ==== ====
Year ended April 2, 1995:
Deducted from asset accounts
Allowance for doubtful accounts $ 15 $ 8 $ 9(1) $ 14
Inventory reserve 121 357 - 478
---- ---- ---- ----
Total $136 $365 $ 9 $492
==== ==== ==== ====
(1) Uncollectible accounts written off, net of recoveries.
(2) Lower of cost or market write down.