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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
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[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED MARCH 29, 1998
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)
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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. [ ]
Aggregate market value of Common Stock held by nonaffiliates (for purposes of
this calculation, only directors and executive officers are considered
affiliates) as of June 16, 1998: $53,711,151
Number of shares of Common Stock outstanding as of the close of business on
June 16, 1998: 6,207,179
DOCUMENTS INCORPORATED BY REFERENCE
Proxy Statement for Annual Meeting of Shareholders, July 31, 1998 ("Proxy
Statement") PART III
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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 national 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 4,000
new and previously played items. Approximately one half of the Company's sales
is previously played merchandise and is sold at an average of half the price for
which these products originally sold. The FUNCOLAND store concept provides
consumers an opportunity to sell their video games that they no longer play and
apply that value toward other previously played or new video games. In addition
to the Company's strong focus on previously played merchandise, the Company
carries a wide selection of new product, featuring competitive prices on hot new
video game releases. 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 29, 1998, the Company operated 250 retail
stores in nineteen major metropolitan areas. This store strategy is complemented
by Funco's mail order operation, the FUNCOLAND SUPERSTORE Web site and
publication of GAME INFORMER(R), a video game magazine with over 190,000 paid
subscribers.
INDUSTRY OVERVIEW
Video games are a preferred form of entertainment for a broad base of
consumers ranging from children to adults. Video game play involves a hardware
game system, or console, typically connected to a television set, together with
video game software which runs on the system. Software is either contained on a
game cartridge or a CD. Along with Sony, Nintendo and Sega, who currently
dominate the video game hardware market, third party publishers such as
Electronic Arts also develop and provide software for these game systems.
The video game industry is subject to rapid technological changes and has
demonstrated a cyclical nature. The industry has introduced new generation
hardware platforms at four to five year intervals. Each subsequent generation
has featured improvements in areas including graphics, processing speed and
sound and has achieved a larger installed base than that of the prior
generation. As technologies advance, consumers look to the manufacturers to
develop gaming systems capable of providing even richer game playing
experiences.
The 8-bit Nintendo system, introduced in 1985, was followed by the 16-bit
Sega Genesis and Super Nintendo systems which arrived on the market in 1989 and
1991, respectively. The 32-bit Sega Saturn and Sony PlayStation and the 64-bit
Nintendo 64 were introduced during calendar years 1995 and 1996. Each generation
of hardware systems has generally followed bell-shaped unit sales curves over
their life cycles, with product prices highest in the introduction stage, then
declining over time. Software sales increase in conjunction with growth of the
installed hardware base and generally peak within a year of each generation's
hardware sales peak.
The industry transition from the 8-bit system to the 16-bit generation
occurred between 1989 and 1991, resulting in a slowdown in overall industry
revenue growth. The Company was opening its first stores at that time and
achieved success with growth and operating results during that period. Overall,
this industry transition was relatively smooth. The transition that occurred in
late 1994 and 1995 led to a significant decrease in overall industry revenues,
adversely impacting the Company's operations. This severe downturn occurred due
to a sharp decline in the appeal of 16-bit product as consumers anticipated the
introduction of 32 and 64-bit products, which were delayed in reaching the
market. The growing popularity of Sony PlayStation which was introduced in late
1995, and Nintendo 64 introduced in 1996, has led the industry to record sales
levels. Video game category revenues reached $5.5 billion in 1997 with the
Company also achieving record results.
The Company expects continued advancements in technology and software
development to drive long-term industry growth. Industry sources forecast
continued sales growth for the current generation
of hardware and software in calendar 1998 and 1999. The first of the next
generation 128-bit hardware platforms, Sega Dreamcast, is being planned for
availability in the United States in late 1999. The success of this product, and
competitive responses from the current industry leaders, Sony and Nintendo, can
be expected to significantly impact this industry for the first few years of the
twenty-first century. Failure of the industry to periodically introduce exciting
new hardware systems and compelling software acceptable to consumers could lead
to future industry downturns, and could affect the Company's operations.
COMPANY STRATEGY
The Company's primary goal is to strengthen its position as a leading
provider of new and previously played interactive entertainment. During fiscal
1999, the Company's primary emphasis will be on further growing its store base
and increasing profitability. The Company expects to enter several new markets
during fiscal 1999 and also add stores in existing markets, with its store count
growing to over 300 by fiscal year end. In future years, the Company expects to
further enhance its position through 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 a broad selection of previously played video game merchandise at
approximately half the price for which these games were originally sold; an
opportunity to sell video games that they no longer play and to apply the
proceeds towards the purchase of other games; and a broad selection of new video
game products including hot new releases at competitive prices.
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. For fiscal 1998, sales of new product were approximately equal to
sales from previously played product, Funco's specialty niche. To assure
customers that they will not sacrifice quality or performance when purchasing
previously played merchandise, the Company provides warranties on all its
products. The Company's previously played 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 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 provides the opportunity for video game players to sell 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 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
eight years the Company has developed and
utilized a model to manage its previously played inventory and to maintain the
desired 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) on a monthly basis. 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 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 seasonal holiday demand. All new stores are
initially set up with inventory shipped from the Company's central 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 pull-backs
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 many new products. The Company expects that new
product quality, pricing, availability, acceptance and market penetration will
affect future operating results.
STORE LOCATIONS AND SITE SELECTION
At March 29, 1998, the Company operated 250 FUNCOLAND stores in nineteen
metropolitan markets. The number of stores open in these markets at each
respective year end date is summarized below:
MARCH 29, MARCH 30, MARCH 31, APRIL 2, APRIL 3,
1998 1997 1996 1995 1994
--------- --------- --------- -------- --------
Central Region:
Minneapolis ........................ 15 14 13 13 12
Dallas ............................. 12 12 12 14 14
Houston ............................ 8 8 7 9 -
Chicago ............................ 31 30 30 34 32
Milwaukee .......................... 8 6 6 6 5
Detroit ............................ 28 24 21 21 14
Kansas City ........................ 5 5 5 5 -
Columbus ........................... 6 - - - -
Indianapolis ....................... 4 - - - -
Louisville ......................... 4 - - - -
St. Louis .......................... 5 - - - -
Cincinnati ......................... 5 - - - -
--- --- --- --- ---
Subtotal Central Region ............. 131 99 94 102 77
East Coast Region:
New York ........................... 39 36 37 38 29
Philadelphia ....................... 21 16 15 16 2
Baltimore/Washington, D.C. ......... 18 15 16 16 2
Boston ............................. 15 13 11 10 -
--- --- --- --- ---
Subtotal East Coast Region .......... 93 80 79 80 33
West Coast Region:
San Francisco ...................... 12 9 - - -
Sacramento ......................... 6 - - - -
Seattle ............................ 8 - - - -
--- --- --- --- ---
Subtotal West Coast Region .......... 26 9 - - -
--- --- --- --- ---
Total Stores ........................ 250 188 173 182 110
=== === === === ===
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 2,900 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. During the year, the Company periodically mails a video
game catalog to individuals on its mailing list. In addition, the Company places
direct response advertising in several leading video game magazines. Net sales
from mail order in fiscal 1998 accounted for approximately 4% of net retail
sales.
FUNCOLAND SUPERSTORE WEB SITE
The Company operates the FUNCOLAND SUPERSTORE Web site, www.funcoland.com,
which provides consumers an exciting means of shopping for video games on-line.
Additionally, the site offers a retail store directory, GAME INFORMER magazine
highlights and monthly game tips. Although revenues from the Web site currently
are minimal, the Company is positioning itself to take advantage of growth in
Internet commerce.
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 1998 issue, the magazine had more than 190,000 paid subscribers. GAME
INFORMER is published by Sunrise Publications, Inc., a wholly-owned subsidiary
of Funco, Inc.
COMPETITION
The console-based video game 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;
toy retailers including Toys "R" Us and KB Toys; consumer electronics
superstores such as Best Buy; and department store chains. Many competitors,
including Babbages Etc. and Electronics Boutique 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 also compete
on price with Funco's previously played products.
Previously played video game merchandise is sold primarily through regional
and local companies. With 250 stores in nineteen metropolitan areas at March 29,
1998, the Company is the nation's leading specialty retailer focusing primarily
on previously played product. The Company is aware of several other companies
with stores in the United States, including It's About Games and MicroPlay, that
buy and sell previously played video games through Company-owned and franchised
stores. In addition to competing with these specialty retail operations in its
current geographic markets, the Company frequently competes with smaller
businesses which buy and sell previously played video game merchandise and with
movie/video rental outlets which may sell games.
Due to the strength of the interactive entertainment industry over the past
two years, the Company believes that both existing competitors and new entrants
may intensify competitive efforts. Both in its existing markets, and as it
expands into new markets, the Company may be required to compete with other
retailers. 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.
As sellers of new and previously played video 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 sales of video games in these
rental outlets will not become a significant source of competition to the
Company in the future.
To date, video game products have been distributed primarily through retail
stores. Other distribution channels for interactive entertainment include
on-line retailing and gaming over 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.
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
three years include Sega Saturn, Sony PlayStation and Nintendo 64. Of these,
Sony PlayStation and Nintendo 64 currently dominate the market. 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.
EMPLOYEES
At March 29, 1998, the Company had 724 full-time employees, including 169
corporate and administrative personnel and 555 store personnel, and 721
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), SUNRISE
PUBLICATIONS(R) and FUNCOLAND, PLUS DESIGN(R) (claim of colors) 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 MORE VIDEO
GAMES AT HALF THE PRICE(TM). 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 250 locations at March 29, 1998, which included 12 locations with
leases under negotiation. The Company's remaining retail store leases effective
as of March 29, 1998 expire as follows:
DURING NUMBER OF
FISCAL YEAR EXPIRING LEASES
----------- ---------------
1999 39
2000 62
2001 105
2002 17
2003 11
2004 and beyond 4
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 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 was a similarly styled class action suit and alleged
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 filed a motion to dismiss the Amended Class Action
Complaint in its entirety.
The parties have reached an agreement-in-principle to settle this lawsuit,
subject to approval by the Court and members of the class. The proposed
settlement will not have a material impact on the Company including its results
of operations, financial condition and liquidity.
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 29, 1998.
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.
1998 Fiscal Quarter 1997 Fiscal Quarter
High Low High Low
First $19 $13 1/4 $9 1/2 $4
Second 23 18 1/8 9 1/4 6 1/8
Third 24 13 1/4 10 8 1/8
Fourth 18 7/8 13 1/8 18 8 3/8
At June 16, 1998, there were 6,207,179 shares of common stock outstanding,
and there were 204 shareholders of record. The Company has not paid any cash
dividends on its common stock and does not anticipate paying cash dividends in
the forseeable future. Under the Company's current bank credit agreement, the
Company is prohibited from paying dividends.
ITEM 6.
SELECTED CONSOLIDATED FINANCIAL DATA
(in thousands, except share and per share data and number of stores)
YEAR ENDED
------------------------------------------------------------------------
MARCH 29, MARCH 30, MARCH 31, APRIL 2, APRIL 3,
1998 1997 1996 1995 1994
--------- --------- --------- -------- --------
Statements of Operations Data
Net sales .................................... $ 163,316 $ 120,555 $ 81,382 $ 80,365 $ 50,490
Net income (loss) ............................ $ 8,270 $ 5,350 $ 205 $ (1,275) $ 880
Net income (loss) per share, basic ........... $ 1.35 $ 0.90 $ 0.03 $ (0.22) $ 0.16
Weighted average number of shares,
basic ....................................... 6,137,161 5,941,744 5,861,682 5,786,719 5,422,140
Net income (loss) per share, diluted ......... $ 1.26 $ 0.86 $ 0.03 $ (0.22) $ 0.15
Weighted average number of shares,
diluted ..................................... 6,572,365 6,228,630 5,965,769 5,786,719 5,805,171
Stores open at end of year ................... 250 188 173 182 110
Balance Sheet Data
Total assets ................................. $ 45,626 $ 31,745 $ 25,668 $ 23,160 $ 24,707
Long-term obligations ........................ $ 156 $ 91 $ 115 $ 485 $ 557
Shareholders' equity ......................... $ 33,525 $ 24,318 $ 18,071 $ 17,800 $ 18,653
The above selected financial data should be read in conjunction with the
consolidated financial statements and related notes beginning on page 18 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
250 at the end of fiscal 1998. The Company has 131 stores in the Central Region,
which includes Minneapolis, Dallas, Houston, Chicago, Milwaukee, Detroit, Kansas
City, Columbus, Indianapolis, Louisville, St. Louis and Cincinnati; 93 stores in
the East Coast Region, which includes New York, Philadelphia,
Baltimore/Washington, D.C. and Boston; and 26 stores in the West Coast Region,
which includes San Francisco, Sacramento and Seattle.
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 factors including new product introductions and 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
marketing programs.
Management believes that most new stores will attain mature store sales
levels within 15 to 18 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. In addition, there can be no
assurance of maintaining sales and profitability at the levels achieved during
fiscal 1998.
RESULTS OF OPERATIONS
The following table sets forth certain items in the statements of income
expressed as percentages of net sales for the years indicated and percentage
changes from the prior year:
PERCENTAGE
YEAR ENDED INCREASE (DECREASE)
------------------------------------- -----------------------
MARCH 29, MARCH 30, MARCH 31, 1998 OVER 1997 OVER
1998 1997 1996 1997 1996
--------- --------- --------- --------- ---------
Net sales .............................. 100.0% 100.0% 100.0% 35.5% 48.1%
Cost of sales .......................... 65.3 63.1 58.6 40.1 59.6
----- ----- -----
Gross profit ........................... 34.7 36.9 41.4 27.6 31.9
Operating expenses ..................... 20.7 23.4 31.5 19.4 10.3
General and administrative expenses..... 5.8 7.1 9.2 10.7 14.2
----- ----- -----
Operating income ....................... 8.2 6.3 0.7 77.1 NA
Interest expense ....................... - - (0.1) (35.5) (55.7)
Interest income ........................ 0.2 0.2 0.2 42.5 68.3
Income tax provision ................... 3.3 2.0 0.5 125.6 NA
----- ----- -----
Net income ............................. 5.1% 4.4% 0.3% 54.6% NA
===== ===== =====
COMPARISON OF FISCAL 1998 TO FISCAL 1997
The Company derived approximately 97% of its fiscal 1998 net sales from
retail operations, which include the Company's mail order and Web site
operations. The balance of net sales was attributable to the publication of GAME
INFORMER magazine. Net sales increased from $120,555,000 in fiscal 1997 to
$163,316,000 during fiscal 1998, an increase of 35.5%. The Company operated 250
stores at the end of fiscal 1998 compared to 188 stores at the end of fiscal
1997. During fiscal 1998 the Company opened 65 new stores while closing 3
locations. Comparable store sales for fiscal 1998 increased 17%. The Company
attributes the strong sales to continued growth of Sony PlayStation and Nintendo
64 product categories.
Cost of sales increased from $76,119,000 in fiscal 1997 to $106,628,000
during fiscal 1998, an increase of 40.1%. 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 63.1% in 1997 to 65.3% in 1998. This increase occurred
primarily as sales mix for fiscal 1998 included proportionately higher sales of
32 and 64-bit products, which are currently sold at higher cost percentages than
earlier generation product offerings.
Operating expenses increased from $28,261,000 in fiscal 1997 to $33,746,000
in fiscal 1998, an increase of 19.4%. This increase is primarily due to higher
store payroll and occupancy expense related to the increased number of locations
compared to prior year. Operating expenses as a percentage of net sales
decreased from 23.4% in fiscal 1997 to 20.7% in fiscal 1998, the result of
improved sales leveraging.
General and administrative expenses increased from $8,592,000 in fiscal
1997 to $9,512,000 in fiscal 1998, an increase of 10.7%. The dollar increase is
primarily due to increased payroll to support corporate functions for a growing
number of stores. General and administrative expenses decreased as a percentage
of net sales from 7.1% in fiscal 1997 to 5.8% in fiscal 1998, the result of
improved sales leveraging.
The Company generated operating income of $13,430,000 in fiscal 1998
compared to $7,583,000 in fiscal 1997, an increase of 77.1%.
Interest expense decreased from $31,000 in fiscal 1997 to $20,000 in fiscal
1998, a decrease of 35.5%, as the Company reduced borrowings on its line of
credit compared to prior year.
Interest income increased from $207,000 in fiscal 1997 to $295,000 in
fiscal 1998, an increase of 42.5%, as the Company maintained higher levels of
cash and cash equivalents throughout most of fiscal 1998 as compared to fiscal
1997.
The Company reported an income tax provision of $5,435,000 in fiscal 1998
compared to $2,409,000 in fiscal 1997, as the Company generated net income
before taxes of $13,705,000 in fiscal 1998 compared
to $7,759,000 in fiscal 1997. The effective tax rate increased primarily as the
Company had reversed a significant valuation allowance in fiscal 1997, which
favorably impacted prior year's tax provision.
As a result of the above factors, the Company generated net income of
$8,270,000, or $1.26 per share in fiscal 1998 compared to $5,350,000, or $0.86
per share in fiscal 1997.
COMPARISON OF FISCAL 1997 TO FISCAL 1996
The Company derived approximately 97% of its fiscal 1997 net sales from
retail operations, which included the Company's mail order operation. 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 attributed 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
was 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 included proportionately higher
sales of 32 and 64-bit products, which were 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 was 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 was
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 reported 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 the 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.
SEASONALITY AND QUARTERLY RESULTS
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. For the 185 stores operating the full 12 months in fiscal 1998, 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 impacted by factors including new product
introductions and 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 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 1998 FISCAL 1997
------------------------------------- ---------------------------------------
1ST 2ND 3RD 4TH 1ST 2ND 3RD 4TH
QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER
------- ------- ------- ------- ------- ------- ------- -------
Net sales .......................... $24,001 $26,760 $67,036 $45,519 $18,862 $20,415 $46,461 $34,817
Gross profit ....................... $ 9,412 $ 9,805 $20,623 $16,848 $ 6,850 $ 7,872 $16,366 $13,348
Operating income (loss) ............ $ 946 $ 796 $ 6,675 $ 5,013 $ (516) $ 32 $ 4,508 $ 3,559
Stores open at quarter end ......... 193 215 249 250 173 176 188 188
Although the results presented above may not be indicative of future trends
or performance, the Company anticipates that quarterly net sales and operating
results 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 1998, 1997 and 1996, the Company had net
cash provided by operating activities of $6,904,000, $3,451,000 and $5,043,000,
respectively. During fiscal 1998, the operating activities which most
significantly impacted cash were net income, an increase in inventory and an
increase in accounts payable.
In fiscal 1998, the Company issued 124,941 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 $937,000. Additionally, the
Company issued 2,748 shares of common stock through the exercise of warrants.
The Company invested $5,380,000 in capital expenditures in fiscal 1998
primarily for new store openings and other store related expenditures. During
fiscal 1999, the Company plans to incur capital expenditures of approximately
$6,500,000 for new store openings, other store expenditures, enhancements to
store and corporate information systems and general corporate purposes.
The Company currently has a $3,000,000 unsecured revolving credit facility
with a commercial bank, which seasonally increases to $10,000,000. The interest
rate on outstanding borrowings under the facility (81|M/2% at March 29, 1998) is
equal to the bank's prime rate. The facility requires the Company to maintain
certain financial ratios and achieve certain operating results. There were no
balances outstanding under this facility at March 29, 1998 or March 30, 1997.
The Company believes that cash from operations, short-term investments 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.
YEAR 2000
The Company is undergoing a company-wide program of adapting its computer
systems and applications for the year 2000. Substantially all in-house developed
software has been written to be year 2000 compliant. The Company's older
systems, some of which are not year 2000 compliant, are in the process of being
modified or upgraded. These system upgrades, which include financial, inventory
and store point-of-sale systems are year 2000 compliant and are being undertaken
primarily to support the Company's growth and to take advantage of advanced
technologies.
The Company believes that it is well positioned to meet the year 2000
challenge, primarily through undertakings expected to be completed in the
current fiscal year. Year 2000 costs have not been material to date and costs
over the next 18 months, if separated from related system enhancements, are
expected to be less than $500,000.
Finally, the Company recognizes that it faces year 2000 risks from its
various business partners, including vendors and service providers. The Company
intends to work with these partners to mitigate our common risks. However, there
can be no assurance that the Company or its business partners will be completely
year 2000 compliant on a timely basis.
FORWARD LOOKING STATEMENTS
Statements in this document 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 including 50 to 60 new stores in fiscal 1999 and believes
that the addition of new stores will continue to be a primary component of the
Company's ongoing growth. 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, that new stores will perform as
anticipated or that existing stores will continue to operate at profitable
levels. 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. In addition to site selection and
lease negotiation, lease renewals are another factor which may impact the
Company's performance. Although the Company does not believe that the
termination of any particular lease would have a material adverse effect on its
business in that similar locations on comparable terms would be available within
the same or in a contiguous market area, results of operations and the Company's
financial condition would be adversely impacted should the Company be
unsuccessful in either renewing or relocating a material number of store
locations.
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 Company's 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 and
subject to rapid changes in consumer preferences, pricing and technology. 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 compete successfully in the sale of either new or
previously played product. Increased competition, in addition to adversely
impacting sales, could also negatively impact product margins, materially
impacting operating profits. In addition, new distribution channels for
interactive entertainment, such as on-line retailing, Internet gaming or other
alternate delivery systems may adversely impact future sales of product through
retail stores such as the Company's. Video games also compete for the consumers'
dollar with many other forms of entertainment such as sporting events, movies,
music and books. Any decrease in video game popularity or shift to other such
forms of entertainment would adversely impact the Company's results of
operations and financial condition.
Although the Company attempts to maintain product mix and inventory levels
which will meet 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 misjudgments by the Company in
assessing product demand or establishing prices, vendor allocations, logistical
difficulties or potential limitations of the Company's management information
systems.
The interactive entertainment industry periodically undergoes technological
advances and developments. Failure to appropriately respond to changing
technological developments could materially adversely impact the Company's
results of operations and financial condition. Introduction of new hardware
systems, or the anticipated introduction of such systems, 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 very important to the
Company's business, both for increasing sales and 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
adversely affect consumer interest in the overall interactive entertainment
product category. (See Item 1. Business -- Industry Overview.)
The Company's business is highly seasonal with the majority of net sales
and net income being generated in the third fiscal quarter which includes the
holiday selling season. Accordingly, events, factors or trends which impact that
quarter could materially impact full year results. General economic conditions
such as high unemployment, high inflation or a falling stock market which could
lead consumers to reduce expenditures during the third fiscal quarter, could
adversely impact the Company's results of operations and financial conditions.
Seasonal patterns would also intensify the impact of factors such as a shortage
of qualified employees or adverse weather conditions. In addition, any failure
by the Company to adequately obtain new or previously played inventory or
failure by manufacturers to deliver key product either to the marketplace or to
the Company would be magnified should those events occur during the fiscal third
quarter.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
None.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial statements required by this item can be found beginning on page
18 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 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 "Election of Directors-Directors'
Compensation" and "Executive Compensation."
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
The information required by this Item 13 is incorporated by reference from
the Proxy Statement section entitled "Certain Transactions."
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 18. All other schedules for which provision is
made in the applicable accounting regulations of the Securities and
Exchange Commission are not required under the related instructions or
are not applicable and therefore have been omitted.
(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, 1997 (Note 3)
*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 options 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 (Note 9)
23 Consent of Independent Auditors
27 Financial Data Schedule
27.1 Restated Financial Data Schedule for fiscal 1998
27.2 Restated Financial Data Schedule for fiscal 1997
27.3 Restated Financial Data Schedule for fiscal 1996
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 1998, filed
on July 31, 1997, and incorporated herein by reference.
Note 4. Filed as an exhibit to Registration Statement on Form S-1 (SEC No.
33-63782) ("Form S-1"), filed on June 3, 1993, and incorporated herein
by reference.
Note 5. Filed as an exhibit to Amendment No. 1 on Form S-1, filed 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 on Form S-18, filed on July 27,
1992, and incorporated herein by reference.
Note 9. Filed as an exhibit to Form 10-K for fiscal year 1997, filed on June
30, 1997, 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 25, 1998.
NAME TITLE
- ---- -----
/s/ DAVID R. POMIJE Chairman of the Board of Directors
- --------------------------------- and Chief Executive Officer
David R. Pomije
/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 ............................................................... 19
Report of Ernst & Young LLP, Independent Auditors .................................. 20
Consolidated Statements of Income for the fiscal years ended March 29, 1998,
March 30, 1997 and March 31, 1996 ................................................. 21
Consolidated Balance Sheets as of March 29, 1998 and March 30, 1997 ................ 22
Consolidated Statements of Cash Flows for the fiscal years ended March 29, 1998,
March 30, 1997 and March 31, 1996 ................................................. 23
Consolidated Statement of Shareholders' Equity for the fiscal years ended
March 29, 1998, March 30, 1997 and March 31, 1996 ................................. 24
Notes to Consolidated Financial Statements ......................................... 25-31
SCHEDULE:
Schedule II -- Valuation and Qualifying Accounts ................................... 32
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 29, 1998 and March 30, 1997, and the related consolidated statements
of income, shareholders' equity and cash flows for each of the three years in
the period ended March 29, 1998. 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 29, 1998 and March 30, 1997, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
March 29, 1998, 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, 1998
FUNCO, INC.
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
YEAR ENDED
-----------------------------------------
MARCH 29, MARCH 30, MARCH 31,
1998 1997 1996
--------- --------- ---------
Net sales ........................................ $ 163,316 $ 120,555 $ 81,382
Cost of sales .................................... 106,628 76,119 47,690
---------- ---------- ----------
Gross profit ..................................... 56,688 44,436 33,692
Operating expenses ............................... 33,746 28,261 25,624
General and administrative expenses .............. 9,512 8,592 7,521
---------- ---------- ----------
Operating income ................................. 13,430 7,583 547
Interest expense ................................. (20) (31) (70)
Interest income .................................. 295 207 123
---------- ---------- ----------
Net income before income taxes ................... 13,705 7,759 600
Income tax provision ............................. 5,435 2,409 395
---------- ---------- ----------
Net income ....................................... $ 8,270 $ 5,350 $ 205
========== ========== ==========
Basic Net Income Per Share:
- ---------------------------
Basic net income per share ....................... $ 1.35 $ 0.90 $ 0.03
Weighted average number of common shares ......... 6,137,161 5,941,744 5,861,682
Diluted Net Income Per Share:
- -----------------------------
Diluted net income per share ..................... $ 1.26 $ 0.86 $ 0.03
Weighted average number of common and common
equivalent shares ............................... 6,572,365 6,228,630 5,965,769
See accompanying notes.
FUNCO, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
MARCH 29, MARCH 30,
1998 1997
--------- ---------
ASSETS
Current Assets
Cash and cash equivalents ..................................... $ 9,295 $ 8,408
Short-term investments ........................................ 1,460 -
Accounts receivable ........................................... 2,127 1,094
Inventories ................................................... 21,487 13,831
Prepaid expenses .............................................. 1,175 782
Current deferred tax asset .................................... 603 532
------- -------
Total current assets ......................................... 36,147 24,647
Net property and equipment ..................................... 8,201 5,954
Long-term deferred tax asset ................................... 1,122 984
Other assets ................................................... 156 160
------- -------
Total assets ................................................... $45,626 $31,745
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities
Accounts payable .............................................. $ 4,834 $ 1,387
Accrued liabilities ........................................... 6,219 5,182
Capital lease obligations ..................................... - 20
Deferred revenue .............................................. 892 747
------- -------
Total current liabilities .................................... 11,945 7,336
Accrued rent ................................................... 156 91
Shareholders' Equity
Common stock, $0.01 par value, (issued and outstanding for 1998
and 1997, respectively: 6,184,477 and 6,056,788) ............. 62 61
Additional paid-in capital .................................... 19,634 18,698
Retained earnings ............................................. 13,829 5,559
------- -------
Total shareholders' equity ................................... 33,525 24,318
------- -------
Total liabilities and shareholders' equity ..................... $45,626 $31,745
======= =======
See accompanying notes.
FUNCO, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEAR ENDED
-------------------------------------
MARCH 29, MARCH 30, MARCH 31,
1998 1997 1996
--------- --------- ---------
Operating Activities
Net income ....................................................... $ 8,270 $ 5,350 $ 205
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization .................................. 3,126 3,283 3,719
Deferred tax asset ............................................. (209) (964) (198)
Net loss on disposal of property and equipment ................. 105 133 227
Changes in operating assets and liabilities:
Accounts receivable ........................................... (1,033) (473) 112
Inventories ................................................... (7,656) (4,056) (1,438)
Prepaid expenses .............................................. (393) 334 (87)
Accounts payable .............................................. 3,447 (1,808) 1,832
Accrued liabilities ........................................... 1,102 1,527 596
Deferred revenue .............................................. 145 125 75
-------- -------- --------
Net cash provided by operating activities ................... 6,904 3,451 5,043
Investing Activities
Additions of property and equipment .............................. (5,380) (1,548) (444)
Increase in other assets ......................................... (110) (98) (60)
Purchase of short-term investments ............................... (1,460) - -
Proceeds from sales of property and equipment .................... 16 3 6
-------- -------- --------
Net cash used in investing activities ....................... (6,934) (1,643) (498)
Financing Activities
Payments of obligations under capital leases ..................... (20) (80) (299)
Net proceeds from issuance of common stock ....................... 937 897 66
-------- -------- --------
Net cash provided by (used in) financing activities ......... 917 817 (233)
-------- -------- --------
Increase in cash and cash equivalents ............................. 887 2,625 4,312
Cash and cash equivalents at beginning of year .................... 8,408 5,783 1,471
-------- -------- --------
Cash and cash equivalents at end of year .......................... $ 9,295 $ 8,408 $ 5,783
======== ======== ========
See accompanying notes.
FUNCO, INC.
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(IN THOUSANDS)
TOTAL
COMMON STOCK ADDITIONAL SHARE-
----------------- PAID-IN RETAINED HOLDERS'
SHARES AMOUNT CAPITAL EARNINGS EQUITY
------- ------ ---------- -------- --------
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
Common stock issued, net of costs ......... 127 1 634 635
Tax benefits of stock options ............. 302 302
Net income ................................ 8,270 8,270
----- --- ------- ------- -------
Balance at March 29, 1998 ................. 6,184 $62 $19,634 $13,829 $33,525
===== === ======= ======= =======
See accompanying notes.
FUNCO, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 29, 1998
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, mail order operation and FUNCOLAND SUPERSTORE Web
site. 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 magazine issues
are delivered.
ADVERTISING COSTS -- Advertising costs, included in operating expenses, are
expensed as incurred and were $2,309,000, $2,898,000 and $2,361,000 for the
years 1998, 1997 and 1996, respectively.
FISCAL YEAR -- The Company's fiscal year ends on a Sunday on or near March
31st. The fiscal years ended March 29, 1998, March 30, 1997 and March 31, 1996
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 investments with a maturity
of three months or less at the time of purchase. Cash equivalents are recorded
at cost, which approximates market.
SHORT-TERM INVESTMENTS -- Short-term investments represent investments with
a maturity of greater than three months at the time of purchase. Realized gains
and losses and declines in value judged to be other-than-temporary on short-term
investments are included in interest income. Short-term investments are recorded
at cost, which approximates market.
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 three to five years.
IMPAIRMENT OF LONG-LIVED ASSETS -- The Company records impairment losses of
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 $75,000 at March 29, 1998 and $86,000 at March 30,
1997.
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."
FUNCO, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
NET INCOME PER SHARE -- The Company has adopted the requirements of
Statement of Financial Accounting Standards No. 128 (SFAS No. 128), "Earnings
Per Share" and has restated all periods presented. This change did not have a
material impact on the computation of net income per share.
Basic net income per share is computed based on the weighted average number
of common shares outstanding during each period. Diluted net income per share
includes the incremental shares assumed issued on the exercise of stock options.
Unless otherwise stated, all references to income per share are calculated using
the diluted method.
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 unsecured revolving credit facility
with a commercial bank, which seasonally increases to $10,000,000. The interest
rate on outstanding borrowings under the facility (81|M/2% at March 29, 1998) is
equal to the bank's prime rate. The facility requires the Company to maintain
certain financial ratios and achieve certain operating results. There were no
outstanding balances under this facility at March 29, 1998 or March 30, 1997.
Total interest paid, including interest on short-term borrowings and
capital leases, was $20,000, $31,000 and $70,000 for the years 1998, 1997 and
1996, respectively.
3. LEASES
CAPITAL LEASES -- The Company had no leased equipment under sale/leaseback
or lease financing arrangements as of March 29, 1998. All previously leased
equipment has been purchased by the Company. Under the Company's previous
sale/leaseback transactions, equipment had 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
----------------------------------------------
Equipment $ 696
Accumulated amortization (669)
----------------------------------------------
Net leased equipment $ 27
==============================================
Amortization of leased assets is included in depreciation and amortization
expense.
Equipment at a cost of $66,000 and $33,000 was acquired in exchange for
obligations under capital leases in the years 1997 and 1996, respectively.
FUNCO, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. LEASES (CONTINUED)
OPERATING LEASES -- The Company has rental commitments for office space,
retail space, office equipment and vehicles 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)
----------------------------------------------
1999 $ 6,484
2000 5,158
2001 2,729
2002 666
2003 389
2004 and beyond 355
----------------------------------------------
Total $15,781
==============================================
Rent expense was $6,215,000, $4,974,000, and $4,677,000 for the years 1998,
1997 and 1996, respectively.
4. NET PROPERTY AND EQUIPMENT CONSIST OF THE FOLLOWING:
(IN THOUSANDS) 1998 1997
-----------------------------------------------------------
Furniture and fixtures $ 5,914 $ 4,273
Equipment 8,025 6,634
Leasehold improvements 7,341 5,627
Other 64 64
-----------------------------------------------------------
Gross property and equipment 21,344 16,598
Less accumulated depreciation (13,143) (10,644)
-----------------------------------------------------------
Net property and equipment $ 8,201 $ 5,954
===========================================================
5. ACCRUED LIABILITIES CONSIST OF THE FOLLOWING:
(IN THOUSANDS) 1998 1997
---------------------------------------------------------------
Purchase credit memos payable $ 1,682 $ 1,731
Employee compensation and related taxes 1,432 1,251
Sales tax payable 790 529
Income tax payable 1,692 875
Other accrued liabilities 623 796
---------------------------------------------------------------
Total accrued liabilities $ 6,219 $ 5,182
===============================================================
FUNCO, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 has been reserved for issuance to directors,
officers and employees, upon the exercise of stock options. Annually, 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 29, 1998, the Company
has reserved an additional 61,845 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 29, 1998 there were 938,893 options outstanding. Options
exercisable at the end of years 1998, 1997 and 1996 were 442,961, 335,120 and
176,737, respectively. A summary of stock option transactions is as follows:
WEIGHTED AVERAGE
EXERCISE PRICE
SHARES PER SHARE
------------------------------------------------------------
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
Granted 286,936 15.37
Exercised 124,771 5.11
Canceled 22,905 10.90
------------------------------------------------------------
Outstanding March 29, 1998 938,893 $ 9.85
============================================================
The following table summarizes information concerning outstanding and
exercisable options:
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
RANGE OF REMAINING AVERAGE AVERAGE
EXERCISE NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE
PRICES OUTSTANDING LIFE (YEARS) PRICE EXERCISABLE PRICE
- ----------------------------------------------------------------------------
$ 0 - $ 4 78,403 6.10 $ 2.54 63,102 $ 2.33
$ 4 - $ 8 288,207 6.54 5.67 190,847 5.61
$ 8 - $12 215,799 6.87 9.28 105,933 9.83
$12 - $16 322,984 7.98 14.95 83,079 14.63
$16 - $20 33,500 4.89 17.44 - -
- ----------------------------------------------------------------------------
$ 0 - $20 938,893 7.01 $ 9.85 442,961 $ 7.85
============================================================================
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 exercisable over four years commencing
August 1993. All such warrants have been exercised.
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 in May 1993. All such warrants have been exercised.
FUNCO, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. STOCK OPTIONS AND WARRANTS (CONTINUED)
In April 1993, the Company granted to a consultant a warrant to purchase
7,000 shares of common stock at $12.75 per share. The warrant was exercisable
for a period of five years commencing June 1, 1993. In fiscal 1998, the Company
issued 2,748 shares of common stock through the exercise of this warrant.
In fiscal 1998, the Company issued 124,941 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 $937,000.
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 the 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 cost been recognized based on fair value at the date of grant, the
Company's pro forma net income and net income per share would have been as
follows:
(IN THOUSANDS EXCEPT PER SHARE DATA) 1998 1997 1996
---------------------------------------------------------------------------
Net income:
As reported $ 8,270 $ 5,350 $ 205
Pro forma 7,594 5,038 87
---------------------------------------------------------------------------
Income per common share -- basic:
As reported $ 1.35 $ 0.90 $ 0.03
Pro forma 1.26 0.86 0.02
---------------------------------------------------------------------------
Income per common share -- diluted:
As reported $ 1.26 $ 0.86 $ 0.03
Pro forma 1.17 0.82 0.01
---------------------------------------------------------------------------
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:
1998 1997 1996
------------------------------------------------------------
Expected volatility 70.1% 74.4% 74.4%
Risk-free interest rate 6.0% 6.0% 6.0%
Expected dividend yield 0.0% 0.0% 0.0%
Expected life of options 3 Years 3 Years 3 Years
------------------------------------------------------------
The pro forma effect on net income and net income per share is not
representative of the pro forma net income 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 with an exercise price equal to
market price granted during years 1998, 1997 and 1996 is $7.65, $4.14 and $2.24
per share, respectively. The weighted average fair value for options with an
exercise price greater than market price granted during years 1998, 1997 and
1996 is $7.03, $4.30 and $2.23, respectively.
FUNCO, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. NET INCOME PER SHARE
In accordance with Statement of Financial Accounting Standards No. 128
(SFAS No. 128) "Earnings Per Share," the following table presents a
reconciliation of the numerators and denominators of basic and diluted net
income per common share for the years 1998, 1997 and 1996:
(IN THOUSANDS EXCEPT SHARE AND PER SHARE DATA) 1998 1997 1996
-------------------------------------------------------------------------------------------------
Numerator:
Net income $ 8,270 $ 5,350 $ 205
=================================================================================================
Denominator:
Denominator for basic net income per share --
weighted average shares 6,137,161 5,941,744 5,861,682
Dilutive securities:
Employee stock options 435,204 286,886 104,087
-------------------------------------------------------------------------------------------------
Denominator for diluted net income per share --
adjusted weighted average shares 6,572,365 6,228,630 5,965,769
=================================================================================================
Basic net income per share $ 1.35 $ 0.90 $ 0.03
=================================================================================================
Diluted net income per share $ 1.26 $ 0.86 $ 0.03
=================================================================================================
8. INCOME TAXES
Significant components of the provision for income taxes for the years
1998, 1997 and 1996 are as follows:
(IN THOUSANDS) 1998 1997 1996
------------------------------------------------------------
Current
Federal $4,346 $2,749 $ 392
State 1,298 624 201
------------------------------------------------------------
Current tax expense 5,644 3,373 593
Deferred
Federal (159) (786) (160)
State (50) (178) (38)
------------------------------------------------------------
Deferred tax expense (209) (964) (198)
------------------------------------------------------------
Net income tax provision $5,435 $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 29, 1998 and March
30, 1997, are as follows:
(IN THOUSANDS) 1998 1997
--------------------------------------------------------
Accrued rent $ 191 $ 66
Inventories 431 419
Depreciation 1,297 1,107
Other (194) (76)
--------------------------------------------------------
Net deferred tax asset $1,725 $1,516
========================================================
The recognized deferred tax asset is based upon expected reversal of
certain temporary differences.
Income taxes of $4,518,000, $2,890,000, and $66,000 were paid in the years
1998, 1997 and 1996, respectively.
FUNCO, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. INCOME TAXES (CONTINUED)
Reconciliation of the Company's tax rate is as follows:
(IN THOUSANDS) 1998 1997 1996
--------------------------------------------------------------------------
Expected tax expense $4,701 $2,638 $ 204
State income tax, net of federal benefit 820 294 133
Change in valuation allowance - (644) 11
Alternative minimum tax expense - - 18
Other (86) 121 29
--------------------------------------------------------------------------
Net income tax provision $5,435 $2,409 $ 395
==========================================================================
Effective tax rate 40% 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 29, 1998:
Deducted from asset accounts
Allowance for doubtful accounts $ 40 $ - $ 11(1) $ 29
Inventory reserve 624 - 270(2) 354
---- ---- -------- ----
Total $664 $ - $ 281 $383
==== ==== ======== ====
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(3) 402
---- ---- -------- ----
Total $492 $196 $ 269 $419
==== ==== ======== ====
- ------------------
(1) Uncollectible accounts written off, net of recoveries.
(2) Inventory previously written off was recovered.
(3) Lower of cost or market write down.