SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_______________
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2001
[_] 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 0-32613
LEARNINGSTAR CORP.
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 77-0559897
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
2 Lower Ragsdale Drive, Suite 200 93940
Monterey, CA (Zip Code)
(Address of Principal Executive Offices)
Registrant's telephone number, including area code: (831) 333-2000
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such report(s), and (2) has been subject to such
filing requirements for the past 90 days. Yes [_] No [X]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date: Common Stock, $.01 par value,
8,333,214 shares outstanding as of May 11, 2001.
LEARNINGSTAR CORP.
TABLE OF CONTENTS
PART I: FINANCIAL INFORMATION................................................................... 3
ITEM 1. FINANCIAL STATEMENTS................................................................... 3
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.. 10
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK............................ 14
PART II: OTHER INFORMATION...................................................................... 14
ITEM 1. LEGAL PROCEEDINGS...................................................................... 14
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.............................................. 14
ITEM 3. DEFAULTS UPON SENIOR SECURITIES........................................................ 14
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.................................... 14
ITEM 5. OTHER INFORMATION...................................................................... 15
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K....................................................... 24
SIGNATURE...................................................................................... 25
PART I: FINANCIAL INFORMATION
LearningStar Corp. ("LearningStar") was incorporated in the State of
Delaware on November 6, 2000 for the purpose of effecting the combination of the
businesses of Earlychildhood LLC, a California limited liability company
("Earlychildhood") and SmarterKids.com, Inc., a Delaware corporation
("SmarterKids.com"). As of March 31, 2001, LearningStar was nominally
capitalized and its balance sheet was comprised solely of common stock
subscriptions receivable of $10.00 and common stock of $10.00 representing 1,000
shares of outstanding common stock at a par value of $0.01 per share.
Accordingly, LearningStar's financial statements are not included in this
Quarterly Report on Form 10-Q.
The combination of Earlychildhood and SmarterKids.com (the "Combination")
was completed on April 30, 2001 and, in connection therewith, each of
Earlychildhood and SmarterKids.com became a wholly-owned subsidiary of
LearningStar. As a result of the Combination, the former holders of outstanding
membership interests in Earlychildhood and options to purchase membership
interests in Earlychildhood own approximately two-thirds of the capital stock of
LearningStar and the former holders of outstanding common stock of
SmarterKids.com and options and warrants to purchase shares of common stock of
SmarterKids.com own approximately one-third of the capital stock of
LearningStar. As the former Earlychildhood members have a controlling interest
in LearningStar following the Combination, the transaction has been recorded for
accounting purposes as if Earlychildhood acquired SmarterKids.com, with
Earlychildhood deemed to be the predecessor of LearningStar. Accordingly,
pursuant to Rules 3-01 through 3-04 of Regulation S-X, Earlychildhood's
unaudited consolidated financial statements are included in Item 1 herein. Given
the nature of the Combination and since SmarterKids.com constitutes a
significant acquisition to Earlychildhood, the corresponding financial
statements of SmarterKids.com for the three months ended March 31, 2001 and 2000
are included herein in Item 5.
ITEM 1. FINANCIAL STATEMENTS
EARLYCHILDHOOD LLC
CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)
March 31, December 31,
--------- ------------
2001 2000
--------- ------------
ASSETS
Current assets:
Cash and cash equivalents .............................................................. $ 107 $ 181
Accounts receivable, net................................................................. 4,774 5,106
Inventories ............................................................................ 24,632 16,929
Prepaid expenses and other current assets ............................................. 1,837 2,051
------- -------
Total current assets ................................................................. 31,350 24,267
Receivable from member ..................................................................... 139 139
Property and equipment, net ................................................................ 4,835 4,690
Other assets................................................................................. 2,044 1,975
Goodwill and other intangible assets, net.................................................... 6,823 7,071
------- -------
Total assets ......................................................................... $45,191 $38,142
======= =======
LIABILITIES AND MEMBERS' EQUITY
Current liabilities:
Bank overdraft ......................................................................... $ 476 $ 1,154
Short-term debt ........................................................................ 14,750 5,188
Accounts payable ....................................................................... 10,354 3,555
Accrued expenses ....................................................................... 2,779 1,860
Income tax related liabilities ......................................................... 12 422
Other current liabilities................................................................ 431 211
------- -------
Total current liabilities ............................................................ 28,802 12,390
Deferred income taxes ...................................................................... 46 66
Notes payable.............................................................................. - 7,250
------- -------
Total liabilities .................................................................... 28,848 19,706
------- -------
Members' equity ............................................................................ 18,782 21,013
Deferred compensation ...................................................................... (2,439) (2,577)
------- -------
Total members' equity ..................................................................... 16,343 18,436
------- -------
Total liabilities and members' equity ..................................................... $45,191 $38,142
======= =======
See accompanying notes to consolidated financial statements.
3
EARLYCHILDHOOD LLC
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands)
(Unaudited)
Three Months Ended
March 31,
--------------------------------
2001 2000
--------------- ------------
Revenues.............................................................. $ 13,929 $ 12,503
Cost of goods sold.................................................... 8,331 7,926
---------- ----------
Gross profit.......................................................... 5,598 4,577
---------- ----------
Operating expenses:
Selling, general and administrative (includes equity-based
compensation of $138 for the three months ended
March 31, 2001)................................................. 7,598 6,447
Amortization of goodwill and other intangible assets.............. 317 282
---------- ----------
7,915 6,729
---------- ----------
Operating loss............................................. (2,317) (2,152)
---------- ----------
Other (income) expense:
Interest expense.................................................. 292 317
Interest income................................................... (2) (15)
---------- ----------
290 302
---------- ----------
Income (loss) before income taxes.............................. (2,607) (2,454)
Income tax benefit.................................................... 376 513
---------- ----------
Net loss.......................................................... $ (2,231) $ (1,941)
========== ==========
Pro forma income tax benefit.......................................... $ (924) $ (864)
========== ==========
Pro forma net loss.................................................... $ (1,679) $ (1,590)
========== ==========
Pro forma net loss per share - basic and diluted...................... $ (0.30) $ (0.29)
========== ==========
Shares used in pro forma per share calculation - basic and diluted.... 5,605,269 5,576,067
========== ==========
See accompanying notes to consolidated financial statements.
4
EARLYCHILDHOOD LLC
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Three Months Ended
March 31,
--------------------------
2001 2000
------- -------
Cash flows from operating activities:
Net loss................................................................................ $(2,231) $(1,941)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization......................................................... 657 438
Equity-based compensation............................................................. 138 --
Deferred income taxes................................................................. (376) (720)
Changes in operating assets and liabilities:
Accounts receivable............................................................. 332 434
Inventories..................................................................... (7,703) (8,506)
Prepaid expenses and other current assets....................................... 214 (902)
Other assets................................................................... (90) 1,068
Accounts payable................................................................ 6,799 7,289
Accrued expenses................................................................ 919 (316)
Income tax related liabilities.................................................. (100) (521)
Other current liabilities....................................................... 219 (93)
------- -------
Net cash used in operating activities..................................................... (1,222) (3,770)
------- -------
Cash flows from investing activities:
Purchase of plant and equipment.................................................... (487) (1,723)
Purchase of other intangible assets................................................ -- (209)
------- -------
Net cash used in investing activities..................................................... (487) (1,932)
------- -------
Cash flows from financing activities:
Bank overdraft..................................................................... (678) --
Borrowings on line of credit....................................................... 2,313 4,000
Principal payments on line of credit............................................... -- (268)
Issuance of membership interests, net of fees...................................... -- 2,000
------- -------
Net cash provided by financing activities................................................. 1,635 5,732
------- -------
Net (decrease) in cash and cash equivalents............................................... (74) 30
Cash and cash equivalents at beginning of period.......................................... 181 151
------- -------
Cash and cash equivalents at end of period................................................ $ 107 $ 181
======= =======
Supplemental disclosures of cash flow information:
Cash payments during the period:
Cash paid for interest............................................................. 292 318
Cash paid for taxes................................................................ 414 521
See accompanying notes to consolidated financial statements.
5
EARLYCHILDHOOD LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(amounts in thousands, except share and per share amounts)
(Unaudited)
1. Basis of Presentation
LearningStar Corp. ("LearningStar") was incorporated in the State of Delaware on
November 6, 2000 for the purpose of effecting the combination of the businesses
of Earlychildhood LLC, a California limited liability company ("Earlychildhood")
and SmarterKids.com, Inc., a Delaware corporation ("SmarterKids.com"). As of
March 31, 2001, LearningStar was nominally capitalized and its balance sheet was
comprised solely of common stock subscriptions receivable of $10.00 and common
stock of $10.00 representing 1,000 shares of outstanding common stock at a par
value of $0.01 per share. The combination of Earlychildhood and SmarterKids.com
(the "Combination") was completed on April 30, 2001 and each of Earlychildhood
and SmarterKids.com became a wholly-owned subsidiary of LearningStar. As a
result of the Combination, the former holders of outstanding membership
interests in Earlychildhood and options to purchase membership interests in
Earlychildhood own approximately two-thirds of the capital stock of LearningStar
and the former holders of outstanding common stock of SmarterKids.com and
options and warrants to purchase shares of common stock of SmarterKids.com own
approximately one-third of the capital stock of LearningStar. As the former
Earlychildhood members have a controlling interest in LearningStar following the
Combination, the transaction has been recorded as if Earlychildhood acquired
SmarterKids.com, with Earlychildhood deemed to be the predecessor of
LearningStar. Accordingly, pursuant to Rules 3-01 through 3-04 of Regulation S-
X, Earlychildhood's financial statements are included in Item 1 herein. A
further discussion of the Combination and condensed pro forma financial
information is included in Note 2.
Earlychildhood, together with its wholly-owned subsidiary, Educational Products,
Inc. ("EPI"), is a fully integrated, multi-channel supplier of educational
products, services and information to schools, educational professionals and
parents serving the early childhood and elementary school communities.
The interim financial statements as of and for the three months ended March 31,
2001 and 2000 have been prepared pursuant to the rules and regulations of the
Securities and Exchange Commission (the "SEC") for interim financial reporting.
These statements are unaudited and, in the opinion of management, include all
adjustments (consisting only of normal recurring adjustments and accruals)
necessary to present fairly the balance sheets and the statements of operations
and cash flows for the periods presented. Operating results for the three months
ended March 31, 2001 may not be indicative of the results for the year ending
December 31, 2001. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with accounting
principles generally accepted in the United States of America have been omitted
in accordance with the rules and regulations of the SEC. These financial
statements should be read in conjunction with the audited consolidated financial
statements of Earlychildhood, and accompanying notes, included in Post-Effective
Amendment No. 2 to LearningStar's Registration Statement on Form S-4 as filed
with the SEC on April 27, 2001.
Shipping and Handling Costs
Shipping and handling revenues and shipping costs are included in revenues and
cost of goods sold, respectively. Handling costs of $1,474 and $1,049 for the
three months ended March 31, 2001 and 2000, respectively, are included in
selling general and administrative expenses.
Reclassifications
Certain reclassifications, not affecting net loss, have been made to prior year
amounts in order to conform to the 2001 financial statement presentation.
Income Taxes
Earlychildhood has elected to be taxed as a limited liability company (LLC) for
federal and state income tax purposes. As an LLC, Earlychildhood's income and
deductions are reported by its members who are taxed on such income or loss.
EPI, a wholly-owned subsidiary of Earlychildhood, is a C corporation and
therefore is subject to federal and state income taxes.
LearningStar will be taxed as a C corporation. Accordingly, Earlychildhood's
consolidated statement of operations for the three months ended March 31, 2001
and 2000 reflect pro forma income taxes as if Earlychildhood had elected to be
taxed as a C corporation for federal and state income tax purposes during those
periods.
6
EARLYCHILDHOOD LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(amounts in thousands, except share and per share amounts)
(Unaudited)
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board (the "FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities" as amended by SFAS No. 137, which
was issued in July 1999, and which delayed the adoption date for SFAS No. 133
until annual periods beginning after June 15, 2000. SFAS No. 133 established
standards for recognition and measurement of derivatives and hedging activities.
Earlychildhood adopted SFAS No. 133 beginning January 1, 2001. The adoption of
SFAS No. 133 did not have a material effect on the financial position or results
of operations of Earlychildhood.
2. Business Combination and Pro Forma Information
On November 14, 2000, Earlychildhood entered into an agreement (as amended, the
"Combination Agreement") to combine with SmarterKids.com. The Combination
Agreement provided for (i) the holders of all of Earlychildhood's outstanding
membership interests to contribute their entire ownership interest in
Earlychildhood for LearningStar common stock and (ii) S-E Educational Merger
Corp., a wholly-owned subsidiary of LearningStar, to be merged with and into
SmarterKids.com and the outstanding shares of SmarterKids.com to be converted
into shares of common stock of LearningStar. In addition, the Combination
Agreement provided for holders of options to purchase Earlychildhood membership
interests and holders of options and warrants to purchase SmarterKids.com common
stock to have their options and warrants exchanged for or converted into, as the
case may be, options or warrants, as applicable, to purchase common stock of
LearningStar. After the exchange, Earlychildhood's members and option holders
would own approximately two-thirds of LearningStar's shares on a fully-diluted
basis.
On April 30, 2001, the Combination was completed. The following table sets forth
LearningStar common shares and options and warrants to purchase common shares
which were issued upon completion of the Combination:
Common Options and
Shares Warrants
------ -----------
Issued in exchange for:
Membership interests in Earlychildhood 5,605,269
Shares of SmarterKids.com 2,725,776
Options of Earlychildhood 193,304
Options and warrants of SmarterKids.com 490,550
--------- --------
8,331,045 683,854
========= ========
The Combination will be accounted for as a purchase of SmarterKids.com by
Earlychildhood. The estimated purchase price of $48,100 is based on the
estimated fair value, determined around the time of announcing the Combination,
of LearningStar common shares, options and warrants issued in exchange for
SmarterKids.com common shares, options and warrants plus estimated transaction
costs.
7
EARLYCHILDHOOD LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(amounts in thousands, except share and per share amounts)
(Unaudited)
The pro forma financial information in the following table illustrates the
combined results of Earlychildhood's operations and the operations of
SmarterKids.com for the three months ended March 31, 2001 and 2000, as if the
acquisition of SmarterKids.com had occurred as of the beginning of each period
presented. The pro forma financial information reflects the combination of
Earlychildhood's and SmarterKids.com's results as adjusted primarily for
amortization of goodwill and intangible assets resulting from the
business combination. The pro forma financial information is presented for
informational purposes and is not necessarily indicative of the results of
operations which would have occurred had Earlychildhood and SmarterKids.com
constituted a single entity as of January 1, 2001 or 2000. The pro forma
information also is not necessarily indicative of the future results of
operations of the combined company.
Three Months Ended
March 31,
--------------------------
2001 2000
------------ ------------
Net sales........................................................ $ 15,800 $ 13,972
Operating loss................................................... $ 11,125 $ 12,374
Pro forma net loss............................................... $ 12,196 $ 11,848
Pro forma basic and diluted net loss per share................... $ (1.49) $ (1.46)
Shares used in pro forma basic and diluted net loss
per share calculation......................................... 8,203,000 8,115,000
3. Unaudited Pro Forma Basic and Diluted Net Loss per Share
The unaudited pro forma basic and diluted net loss per share information
included in the accompanying statements of operations for the three months ended
March 31, 2001 and 2000 reflects the impact of the conversion of all
Earlychildhood membership interests into common shares of LearningStar in
conjunction with the Combination as of the beginning of each period or date of
issuance, if later. Common equivalent shares of 20,233 have not been included in
the computation of diluted net loss per share for the three months ended March
31, 2001 as the effect is anti-dilutive. Common equivalent shares consist of
membership interests issuable upon the exercise of options granted in September
2000.
Historical basic and diluted net loss per share have not been presented because
they are irrelevant due to the significant change in LearningStar's capital
structure and resultant basic and diluted net loss per share that will result
upon conversion of all Earlychildhood membership interests into common shares of
LearningStar.
The following table sets forth the computation of pro forma basic and diluted
net loss per share for the three months ended March 31, 2001 and 2000.
Three Months Ended
March 31,
--------------------------------
2001 2000
Pro forma net loss.................................................... $ (1,679) $ (1,590)
Weighted average shares outstanding assuming conversion of
membership interests to LearningStar common stock:
Class A membership interests 2,942,242 2,942,242
Class B membership interests 2,621,124 2,621,124
Class C membership interests 41,903 12,701
----------- -----------
Shares used in pro forma per share calculation - basic and
diluted 5,605,269 5,576,067
=========== ===========
Pro forma net loss per share - basic and diluted $ (0.30) $ (0.29)
=========== ===========
8
EARLYCHILDHOOD LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(amounts in thousands, except share and per share amounts)
(Unaudited)
4. Segment Information
Earlychildhood presently operates in two segments, Discount School Supply
(DSS) and EPI. DSS includes the brand names Discount School Supply,
Earlychildhood NEWS and Earlychildhood. DSS supplies educational products
and information through multiple channels to early childhood professionals and
parents. EPI sells school supplies to elementary schools, teachers and other
educational organizations.
The accounting policies of the reportable segments are the same as those
described in the summary of significant accounting policies. There were no
intersegment sales. Earlychildhood's profit measure of EBITDA represents net
income adding back depreciation and amortization, interest and income taxes.
Information regarding DSS and EPI is as follows (in thousands):
Three Months Ended
March 31,
-------------------------
2001 2000
---------- -----------
Revenues:
DSS......................................... $11,945 $10,380
EPI......................................... 1,984 2,123
---------------------
Total....................................... 13,929 12,503
======= =======
EBITDA:
DSS......................................... $ (675) $ (772)
EPI......................................... (984) (941)
---------------------
Total....................................... $(1,659) $(1,713)
======= =======
DSS performs limited administrative activities, including certain accounting and
information system functions on behalf of EPI. DSS charges EPI based on
estimates of its actual costs for such activities. Intersegment charges
amounted to $27,000 and $37,000 for the three months ended March 31, 2001 and
2000, respectively.
5. Subsequent Event
In April 2001, LearningStar entered into a secured credit facility with GMAC
Business Credit, LLC ("GMAC"). At the same time, Earlychildhood repaid its
obligations aggregating $16,389 under its existing credit facility with BNP
Paribas (the "Paribas Credit Facility") and the Paribas Credit Facility was
terminated. Accordingly, borrowings under the Paribas Credit Facility are
reflected as current obligations as of March 31, 2001.
LearningStar's credit facility with GMAC includes a $25,000 line of credit with
a maturity of April 30, 2004, an interest rate of LIBOR plus 3.0% and a minimum
excess availability requirement of $4,000 at all times. The facility has a
credit limit at any time of an amount equal to the sum of 80% of the aggregate
face amount of eligible accounts receivable plus the lowest of (i) 50% of
LearningStar's inventory; (ii) 85% times net liquidation percentage of inventory
(the liquidation percentage is periodically set by the lender); or (iii) the
result of $18,000 minus the eligible portion of EPI's inventory. The credit line
also requires certain financial covenants and restrictions on capital
expenditures during the term of the facility. As of May 1, 2001, LearningStar
had borrowings of $5,000 and available borrowing capacity of $4,000 under the
new credit facility with GMAC.
9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion contains forward-looking statements which involve risks
and uncertainties. LearningStar makes these forward-looking statements under the
provision of the "Safe Harbor" section of the Private Securities Litigation
Reform Act of 1995. Any forward-looking statements should be considered in light
of the factors described in the risk factors attached hereto as Exhibit 99.1 and
incorporated herein by reference. Actual results may vary materially from those
projected, anticipated or indicated in any forward-looking statements. In this
Item 2, the words "anticipates," "believes," "expects," "intends," "future,"
"could," and similar words or expressions (as well as other words or expressions
referencing future events, conditions, or circumstances) identify forward-
looking statements. The following discussion and analysis should be read in
conjunction with the accompanying financial statements and related notes
included elsewhere in this Quarterly Report on Form 10-Q.
Overview
LearningStar was incorporated in the State of Delaware on November 6, 2000 for
the purpose of effecting the Combination of the businesses of Earlychildhood and
SmarterKids.com. As of March 31, 2001, LearningStar was nominally capitalized
and its balance sheet was comprised solely of common stock subscriptions
receivable of $10.00 and common stock of $10.00 representing 1,000 shares of
outstanding common stock at a par value of $0.01 per share. The Combination was
completed on April 30, 2001 and each of Earlychildhood and SmarterKids.com
became a wholly-owned subsidiary of LearningStar. As a result of the
Combination, the former holders of outstanding membership interests in
Earlychildhood and options to purchase membership interests in Earlychildhood
own approximately two-thirds of the capital stock of LearningStar and the former
holders of outstanding common stock of SmarterKids.com and options and warrants
to purchase shares of common stock of SmarterKids.com own approximately one-
third of the capital stock of LearningStar. As the former Earlychildhood members
have a controlling interest in LearningStar following the Combination, the
transaction has been recorded as if Earlychildhood acquired SmarterKids.com,
with Earlychildhood deemed to be the predecessor of LearningStar. Accordingly,
Earlychildhood's results of operations and financial condition are discussed
below. A further discussion of the Combination is included under "Combination
with SmarterKids.com" below.
Earlychildhood is a fully-integrated, multi-channel supplier of educational
products, services and information to schools, educational professionals and
parents serving the early childhood and elementary school communities. Through a
predecessor entity, Earlychildhood began operations in 1985. Earlychildhood
manufactures, imports and sells company-developed products as part of its
diverse mix of school supplies and educational toys, while also distributing and
selling a carefully selected range of third-party brands such as Crayola(R),
Lego(R) and Elmer's(R). Earlychildhood utilizes multiple sales, marketing and
distribution channels, including:
. its catalogs issued under its tradename, Discount School Supply, or DSS;
. sales programs conducted through its wholly-owned subsidiary, Educational
Products, Inc., or EPI;
. the Earlychildhood website; and
. Earlychildhood NEWS, a professional content resource published in print and
online.
All of the foregoing are supported by a national sales force which, as of
March 31, 2001, numbered 85 people.
Earlychildhood presently operates in two segments: Discount School Supply, or
DSS, and EPI. DSS includes the brand names Discount School Supply,
Earlychildhood NEWS and Earlychildhood. DSS supplies educational products
and information through multiple channels to early childhood professionals and
parents. EPI sells school supplies to elementary schools, teachers and other
educational organizations. LearningStar is in the process of reviewing its
organizational reporting and, as such, operating segments may be subject to
change in the future.
10
Combination with SmarterKids.com
On November 14, 2000, Earlychildhood entered into an agreement (as amended, the
"Combination Agreement") to combine with SmarterKids.com. The Combination
Agreement provided for (i) the holders of all of Earlychildhood's outstanding
membership interests to contribute their entire ownership interest in
Earlychildhood for LearningStar common stock and (ii) S-E Educational Merger
Corp., a wholly-owned subsidiary of LearningStar, to be merged with and into
SmarterKids.com and the outstanding shares of SmarterKids.com to be converted
into shares of common stock of LearningStar. In addition, the agreement provided
for holders of options to purchase Earlychildhood membership interests and
holders of options and warrants to purchase SmarterKids.com common stock to have
their options and warrants exchanged for or converted into, as the case may be,
options or warrants, as applicable, to purchase common stock of LearningStar.
After the exchange, Earlychildhood's members and option holders would own
approximately two-thirds of LearningStar's shares on a fully-diluted basis.
On April 30, 2001, the Combination was completed. The following table reflects
LearningStar common shares and options and warrants to purchase common shares
which were issued upon completion of the Combination:
Common Options and
Shares Warrants
------ -----------
Issued in exchange for:
Membership interests in Earlychildhood 5,605,269
Shares of SmarterKids.com 2,725,776
Options of Earlychildhood 193,304
Options and warrants
of SmarterKids.com 490,550
--------- --------
8,331,045 683,854
========= ========
The Combination will be accounted for as a purchase of SmarterKids.com by
Earlychildhood. The estimated purchase price of $48.1 million is based on the
estimated fair value, determined around the time of announcing the Combination,
of LearningStar common shares, options and warrants issued in exchange for
SmarterKids.com common shares, options and warrants plus estimated transaction
costs.
11
Results of Operations
Revenues. Revenues were $13.9 million and $12.5 million for the three months
- ---------
ended March 31, 2001 and 2000, respectively. The increase in revenue from 2000
to 2001 of $1.4 million, or 11.2%, was attributable to increases at DSS of $1.6
million and a decrease in EPI's revenue of $100,000. DSS's contribution to
increased revenue is attributable to increases in its customer base and the
number of pages per catalog, catalogs sent and products offered.
Gross Profit. Gross profit was $5.6 million and $4.6 million for the three
- -------------
months ended March 31, 2001 and 2000, respectively. Gross profit as a percentage
of sales increased from 36.6% to 40.2%. The increase in gross profit percentage
was primarily attributable to increased margins at DSS resulting from pricing
strategy, greater efficiencies in paint manufacturing and economies of scale
associated with purchasing inventory.
Selling, General and Administrative Expenses. Selling, general and
- ---------------------------------------------
administrative expenses include wages and commissions, catalog costs, operating
expenses (which include customer service and certain warehouse costs),
administrative costs (which include information systems, accounting and human
resources), e-business costs and depreciation of property and equipment.
Selling, general and administrative expenses were $7.6 million and $6.4 million
for the three months ended March 31, 2001 and 2000, respectively. The increase
in selling, general and administrative expense was partially attributable to the
addition of a new warehouse facility in Salinas, California as well as the
expansion of Earlychildhood's Harrisburg, Pennsylvania facility. The remaining
costs were related to investment in DSS's marketing and infrastructure,
including personnel, catalog production and fulfillment capacity.
Amortization of Goodwill and Other Intangible Assets. Amortization of goodwill
- -----------------------------------------------------
and other intangible assets was comparable for the three months ended
March 31, 2001 and 2000.
Interest Expense. Interest expense was $292,000 and $318,000 in the three months
- -----------------
ended March 31, 2001 and 2000, respectively. The decrease in interest expense is
primarily related to more favorable LIBOR rates with respect to the interest
rate charged per the Paribas Credit Facility.
Income Tax Benefit. As a limited liability company, Earlychildhood is not
- -------------------
subject to income taxes; however, its wholly-owned subsidiary, EPI, is a C
corporation, and is therefore subject to federal and state income taxes. Income
tax benefit was $376,000 and $513,000 for the three months ended March 31, 2001
and 2000, respectively. The effective income tax rates were 14% and 21% for
March 31, 2001 and 2000, respectively. The effective rates were lower than
statutory rates primarily due to the impact of losses relating to DSS's
operations for which no tax benefit is derived due to Earlychildhood's LLC
status.
Liquidity and Capital Resources
Historically, Earlychildhood's primary cash needs have been for working capital,
capital expenditures and acquisitions to fund its growth. The primary sources of
liquidity have been the Paribas Credit Facility and capital contributions from
its members. As of March 31, 2001, Earlychildhood had net working capital of
$2.5 million. Capitalization consisted of limited liability company membership
interests of $16.3 million.
As a result of the Combination, LearningStar received access to approximately
$23 million of SmarterKids.com pre-combination cash balance and short-term
investments. In addition, in April 2001, LearningStar entered into a secured
credit facility with GMAC Business Credit, LLC (the "GMAC Facility"). At the
same time, Earlychildhood repaid its obligations aggregating $16,389,000 under
the Paribas Credit Facility and the facility was terminated. Accordingly,
borrowings under the Paribas Credit Facility are reflected as a current
obligation as of March 31, 2001.
The GMAC Facility includes a $25 million line of credit with a maturity of April
30, 2004, and interest rate of LIBOR plus 3.0% and a minimum excess availability
requirement of $4.0 million at all times. The facility has a credit limit at any
time of an amount equal to the sum of 80% of the aggregate face amount of
eligible accounts receivable; plus the lowest of (i) 50% of LearningStar's
inventory; (ii) 85% times net liquidation percentage of inventory (the
liquidation percentage is periodically set by the lender); or (iii) the result
of $18 million minus the eligible portion of EPI's inventory. The credit line
also requires certain financial covenants and restrictions on capital
expenditures during the term of the facility. As of May 1, 2001, LearningStar
had borrowings of $5 million and available borrowing capacity of $4 million
under the GMAC Facility.
Management anticipates that operating cash requirements for LearningStar will be
higher in the near future than historical cash requirements at Earlychildhood
due to the costs associated with integrating Earlychildhood and
12
SmarterKids.com. However, it is anticipated that the operating cash flows
relating to the SmarterKids.com component of LearningStar will be significantly
lower than SmarterKids.com's historical operating cash outflows.
Management believes that available cash on hand subsequent to the combination
and availability under the GMAC revolving credit facility will provide adequate
funds for LearningStar's foreseeable working capital needs and planned capital
expenditures.
During the three months ended March 31, 2001, Earlychildhood's operating
activities used $1.2 million in cash. The use of cash was primarily related to
operating losses and increases in inventories, offset in part by increases in
accounts payable. Earlychildhood generated $1.6 million in cash from financing
activities. The cash generated from financing activities was primarily related
to borrowings on the line of credit.
During the three months ended March 31, 2001, Earlychildhood's investing
activities used $487,000 in cash; primarily related to purchases of plant and
equipment.
Earlychildhood's ability to fund its operations, make scheduled debt payments
and planned capital expenditures and to remain in compliance with its financial
covenants under its credit facility depends on its future operating performance
and cash flow, which in turn, are subject to prevailing economic conditions and
to financial, business and other factors, some of which are beyond its control.
Seasonality
Earlychildhood's seasonal sales trends coincide with the start of each school
year. Accordingly, the majority of revenues are generated in the second and
third calendar quarter, with a particular emphasis on the third quarter which
generally represents 40% to 50% of Earlychildhood's annual sales.
Earlychildhood's working capital needs are greatest during the second calendar
quarter as inventory levels are increased to meet seasonal demands.
Inflation
Inflation has and is expected to have only a minor effect on Earlychildhood's
results of operations and sources of liquidity.
Recent Accounting Pronouncements
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" as amended by SFAS No. 137, which was issued
in July 1999, and which delayed the adoption date for SFAS No. 133 until annual
periods beginning after June 15, 2000. SFAS No. 133 established standards for
recognition and measurement of derivatives and hedging activities.
Earlychildhood adopted SFAS No. 133 beginning January 1, 2001. The adoption of
SFAS No. 133 did not have a material effect on the financial position or
operations of Earlychildhood.
13
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The following discussion of market risk includes "forward-looking statements"
that involve risks and uncertainties. Actual results could differ materially
from those projected in the forward-looking statements. LearningStar does not
use derivative financial instruments for speculative or trading purposes.
Interest Rate Risk
LearningStar's financial instruments include cash and cash equivalents, accounts
receivable, accounts payable and a revolving line of credit. Market risks
relating to operations result primarily from a change in interest rates.
LearningStar's borrowings are primarily dependent upon LIBOR rates. In April
2001, LearningStar entered into the GMAC Facility with initial outstanding
borrowings of $5 million as of May 1, 2001. The estimated fair value of
borrowings under the GMAC Facility is expected to approximate its carrying
value.
Credit Risk
Financial instruments which potentially subject LearningStar to concentrations
of credit risk consist primarily of cash, cash equivalents, accounts receivable
and the revolving line of credit. LearningStar has no customer comprising
greater than 10% of its revenues. However, receivables arising from the normal
course of business are not collateralized and management continually monitors
the payment of its accounts receivable and the financial condition of its
customers to reduce the risk of loss. LearningStar does not believe that its
cash and cash equivalents are subject to any unusual credit risk beyond the
normal credit risk associated with commercial banking relationships.
Foreign Currency Risk
LearningStar purchases some of its products from foreign vendors. Accordingly,
LearningStar's prices of imported products are subject to variability based on
foreign exchange rates. However, LearningStar's purchase orders are denominated
in U.S. dollars and LearningStar does not enter into long-term purchase
commitments.
PART II: OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In a demand letter dated July 13, 1999, Showboard, Inc. claimed that one of
EPI's products infringed on Showboard's single and double-wall display
board patents (U.S. Patent Nos. 4,794,712, 5,293,705, and 5,911,522). The EPI
product at issue was EPI's single-wall display boards, which are used primarily
for the display of science projects. By letter dated March 6, 2000, counsel to
Earlychildhood responded that Earlychildhood did not believe that these patents
were infringed because EPI's display boards are not substantially similar to
those of Showboard. No response has been received from Showboard. No complaint
has been filed, nor is any litigation pending over this issue.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
14
ITEM 5. OTHER INFORMATION
(a) Financial Statements of SmarterKids.com, Inc.
As a result of the Combination, the former holders of outstanding membership
interests in Earlychildhood and options to purchase membership interests in
Earlychildhood own approximately two-thirds of the capital stock of LearningStar
and the former holders of outstanding common stock of SmarterKids.com and
options and warrants to purchase shares of common stock of SmarterKids.com own
approximately one-third of the capital stock of LearningStar. As the former
Earylchildhood members have a controlling interest in LearningStar following the
Combination, the transaction has been recorded for accounting purposes as if
Earlychildhood acquired SmarterKids.com, with Earlychildhood deemed to be the
predecessor of LearningStar. Accordingly, pursuant to Rules 3-01 and 3-04 of
Regulation S-X, Earlychildhood's financial statements are included in Item 1
herein. Given the nature of the Combination and since SmarterKids.com
constitutes a significant acquisition to Earlychildhood, the corresponding
financial statements of SmarterKids.com for the three months ended March 31,
2001 and 2000 are included below.
SMARTERKIDS.COM, INC.
BALANCE SHEET
-------------
(in thousands, except share data)
(Unaudited)
March 31, December 31,
--------- ------------
2001 2000
---- ----
ASSETS
Current assets:
Cash and cash equivalents.............................................................. $ 24,011 $ 17,557
Short-term investments................................................................. 1,083 13,831
Accounts receivable, net of allowance for doubtful accounts of $0 and $9 at
March 31, 2001 and December 31, 2000, respectively................................... 79 232
Inventories............................................................................ 462 2,080
Other current assets................................................................... 1,845 1,844
-------- --------
Total current assets............................................................. 27,480 35,544
Property and equipment, net................................................................ 4,981 5,296
Other assets............................................................................... 1,468 1,546
Intangible assets, net..................................................................... 187 274
Restricted cash............................................................................ 1,028 1,028
-------- --------
Total assets..................................................................... $ 35,144 $ 43,688
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long term debt and capital lease obligations........................ $ 518 $ 525
Accounts payable....................................................................... 2,674 5,089
Accrued expenses....................................................................... 6,371 4,418
Deferred revenue....................................................................... 176 188
Other current liabilities.............................................................. - 30
-------- --------
Total current liabilities........................................................ 9,739 10,250
Long term debt and capital lease obligations, net of current portion....................... 547 685
-------- --------
Total liabilities................................................................ 10,286 10,935
-------- --------
Commitments and contingencies (Note 4) - -
Stockholders' equity:
Common stock, $0.01 par value; 90,000,000 shares authorized; 20,832,711
and 20,668,849 shares issued and outstanding at March 31, 2001 and
December 31, 2000, respectively....................................................... 208 207
Additional paid-in capital............................................................. 111,488 111,809
Deferred stock compensation............................................................ (2,467) (3,399)
Accumulated deficit.................................................................... (84,371) (75,864)
-------- --------
Total stockholders' equity........................................................ 24,858 32,753
-------- --------
Total liabilities and stockholders' equity........................................ $ 35,144 $ 43,688
======== ========
The accompanying notes are an integral part of these financial statements.
15
SMARTERKIDS.COM, INC.
STATEMENT OF OPERATIONS
(in thousands, except per share data)
(Unaudited)
For the
Three Months Ended
March 31,
--------------------
2001 2000
---- ----
Net revenues.................................................................. $ 1,871 $ 1,469
Cost of revenues.............................................................. 1,875 1,101
------- -------
Gross profit (loss)........................................................... (4) 368
------- -------
Operating expenses:
Marketing and sales (including stock compensation of $204 and $309 for
the three months ended March 31, 2001 and 2000, respectively)............ 3,772 7,609
Development (including stock compensation of $49 and $(281) for the three
months ended March 31, 2001 and 2000, respectively)...................... 823 662
General and administrative (including stock compensation of $316 and $150
for the three months ended March 31, 2001 and 2000, respectively)........ 812 1,056
Restructuring costs....................................................... 2,315 -
------- -------
Total operating expenses............................................ 7,722 9,327
------- -------
Loss from operations.......................................................... (7,726) (8,959)
Interest and other income (expense), net...................................... (781) 828
------- -------
Net loss attributable to common stockholders.................................. $(8,507) $(8,131)
======= =======
Basic and diluted net loss per common share................................... $ (0.41) $ (0.40)
Weighted average shares outstanding-basic and diluted......................... 20,785 20,308
The accompanying notes are an integral part of these financial statements.
16
SMARTERKIDS.COM, INC.
STATEMENT OF CASH FLOWS
(in thousands)
(Unaudited)
For the
Three Months Ended
March 31,
----------------------------
2001 2000
--------- --------
Cash flows from operating activities:
Net loss .............................................................................. $(8,507) $ (8,131)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization ....................................................... 672 365
Stock compensation expense .......................................................... 569 178
Changes in assets and liabilities:
Accounts receivable .............................................................. 153 92
Inventories ...................................................................... 1,618 1,665
Other current assets ............................................................. (1) (324)
Other long-term assets ........................................................... 78 --
Accounts payable ................................................................. (2,415) (7,397)
Accrued expenses ................................................................. 1,953 (2,571)
Deferred revenue................................................................... (12) (31)
Other current liabilities.......................................................... (30) (15)
------- --------
Net cash used in operating activities ................................................... (5,922) (16,169)
------- --------
Cash flows from investing activities:
Purchase of short-term investments ............................................... -- (21,702)
Purchases of property and equipment .............................................. (270) (1,742)
Sale of short-term investments ................................................... 12,748 --
------- --------
Net cash provided by (used in) investing activities ..................................... 12,478 (23,444)
------- --------
Cash flows from financing activities:
Proceeds from long-term borrowings................................................. -- 1,267
Repayments of long-term borrowings................................................. (145) (100)
Proceeds from exercise of common stock options ................................... 18 13
Proceeds from the purchase of common stock under the Employee Stock
Purchase Plan...................................................................... 25 --
Increase from estimated IPO costs.................................................. -- (204)
------- --------
Net cash provided by (used in) financing activities ..................................... (102) 976
------- --------
Net increase (decrease) in cash and cash equivalents .................................... 6,454 (38,637)
Cash and cash equivalents at beginning of period ........................................ 17,557 55,621
------- --------
Cash and cash equivalents at end of period .............................................. $24,011 $ 16,984
======= ========
The accompanying notes are an integral part of these financial statements.
17
SMARTERKIDS.COM, INC.
NOTES TO FINANCIAL STATEMENTS
-----------------------------
(Unaudited)
1. Basis of Presentation:
The interim financial statements as of and for the three months ended March
31, 2001 and 2000 have been prepared by SmarterKids.com, Inc.
("SmarterKids.com") pursuant to the rules and regulations of the Securities and
Exchange Commission (the "SEC") for interim financial reporting. These
statements are unaudited and, in the opinion of management, include all
adjustments (consisting only of normal recurring adjustments and accruals)
necessary to present fairly the balance sheet and the statements of operations
and cash flows for the periods presented. Operating results for the three months
ended March 31, 2001 and 2000 may not be indicative of the results for the year
ending December 31, 2001. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles have been omitted in accordance with the rules and
regulations of the SEC. These financial statements should be read in conjunction
with the audited financial statements and accompanying notes included in
SmarterKids.com's Annual Report on Form 10-K for the year ended December 31,
2000.
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the
disclosures of contingent liabilities at the period end, and the reported
amounts of revenues and expenses during the reporting period. Actual results
could differ from those estimates.
Marketing and Sales Expenses
Marketing and sales expenses consist primarily of the cost of advertising
and promotional activities, fulfillment costs, including service fees to J.L.
Hammett Co. in 2000, commissions to online marketing companies and expenses for
personnel engaged in marketing and merchandising. Fulfillment costs represent
costs incurred in operating and staffing the distribution center and the
customer service department, picking and packing customers' orders for shipment,
responding to inquires from customers, credit card fees, as well as fees paid to
J.L. Hammett Co., a fulfillment partner during the first six months of 2000. As
of July 1, 2000, SmarterKids.com discontinued using J.L. Hammett Co. as a third
party fulfillment partner due to the opening of its own distribution facility.
Fulfillment costs were $1,085,000 and $1,068,000 for the quarters ended March
31, 2001 and 2000, respectively. Advertising costs are charged to operations as
incurred. Advertising expenses were $540,000 and $3,849,000 for the quarters
ended March 31, 2001 and 2000, respectively.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities" as amended by SFAS No. 137, which
was issued in June 2000. SmarterKids.com adopted SFAS No. 133 in the first
quarter of 2001. SFAS No. 133 requires that all derivative instruments be
reported on the balance sheet at their fair value. Changes in the fair value of
derivatives are recorded each period in current earnings or other comprehensive
income, depending on whether a derivative is designated as part of a hedge
transaction and, if it is, the type of hedge transaction. Adoption of SFAS No.
133 did not have a significant impact on SmarterKids.com's financial condition,
results of operations, or business practices.
18
SMARTERKIDS.COM, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
------------------------------------------
(Unaudited)
2. Property and Equipment:
Property and equipment consist of the following (in thousands):
March 31, December 31,
--------- -----------
2001 2000
--------- -----------
Software ............................................ $1,951 $1,868
Furniture and fixtures .............................. 234 232
Computer and office equipment ....................... 4,251 4,066
Leasehold improvements .............................. 1,275 1,275
------ ------
7,711 7,441
Less--Accumulated depreciation and amortization ..... 2,730 2,145
------ ------
$4,981 $5,296
====== ======
3. Restructuring Charges
During the fourth quarter of 2000, SmarterKids.com approved and implemented
a restructuring program in order to reduce operating expenses in its business.
The restructuring plan is expected to be completed by June 2001. The program
included a net reduction of 60% of SmarterKids.com's workforce. Accordingly,
during the fourth quarter of 2000, SmarterKids.com recorded a charge of $1.3
million related to employee termination benefits. During the first quarter of
2001, SmarterKids.com amended its plan to further include the closing of its
warehouse facility in Mansfield, Massachusetts and the transfer of its
fulfillment operations to Earlychildhood. Accordingly, SmarterKids.com recorded
an additional charge of $2.3 million, reflecting lease termination costs and a
write-off of abandoned fixed assets, net of expected sale proceeds. As of March
31, 2001, $540,000 has been paid out and $3.1 million remains accrued.
Commitments and Contingencies:
4. Restricted Time Deposit
In connection with a facility lease entered into in 1999, SmarterKids.com
is required to maintain, on behalf of the landlord, a certificate of deposit in
the amount of $500,000, which is restricted as to its use. In connection with
the warehouse facility lease entered into in the second quarter of 2000,
SmarterKids.com was required to maintain, on behalf of the landlord, $500,000 in
an interest-bearing account, which was restricted as to its use. The warehouse
facility lease was terminated as of April 30, 2001 in connection with the
restructuring plan SmarterKids.com adopted in the first quarter of 2001 (Note
3).
5. Subsequent events
In November 2000, SmarterKids.com entered into a Contribution Agreement and
Plan of Reorganization and Merger with Earlychildhood, LearningStar and S-E
Educational Merger Corp. This contribution agreement provides for the
combination of SmarterKids.com with Earlychildhood. The shareholders of
SmarterKids.com approved the Contribution Agreement on April 9, 2001 at the
Special Meeting of SmarterKids.com Shareholders. Pursuant to this Contribution
Agreement, the combination of SmarterKids.com and Earlychildhood was effected on
April 30, 2001 by (1) the merger of S-E Educational Merger Corp. with and into
SmarterKids.com such that SmarterKids.com became a wholly-owned subsidiary of
LearningStar, and (2) the contribution of all the outstanding membership
interests in Earlychildhood to LearningStar, such that Earlychildhood became a
wholly-owned subsidiary of LearningStar.
19
(b) SmarterKids.com Management's Discussion and Analysis of Financial
Condition and Results of Operations
Management's Discussion and Analysis of Financial Condition and Results of
Operations should be read in conjunction with the accompanying financial
statements for the periods specified and the associated notes. Further reference
should be made to SmarterKids.com's Annual Report on Form 10-K for the year
ending December 31, 2000.
The following discussion contains forward-looking statements which involve risks
and uncertainties. LearningStar makes such forward-looking statements under
the provision of the "Safe Harbor" section of the Private Securities Litigation
Reform Act of 1995. Any forward-looking statements should be considered in
light of the factors described below under "Certain Factors That May Affect
Future Results." Actual results may vary materially from those projected,
anticipated or indicated in any forward-looking statements. The words
"anticipates," "believes," "expects," "intends," "future," "could," and similar
words or expressions (as well as other words or expressions referencing future
events, conditions, or circumstances) identify forward-looking statements. The
following discussion and analysis should be read in conjunction with the
accompanying financial statements and related notes included elsewhere in this
Quarterly Report on Form 10-Q.
Overview
SmarterKids.com is an online, educational store dedicated to helping parents
help their children learn, develop, and grow. The site offers what management
believes to be one of the Internet's most personalized shopping experiences,
linking teacher-reviewed toys, games, books, software, and hands-on activities
through SmarterKids.com's patent-pending evaluation and recommendation process.
SmarterKids.com serves as a resource for parents, offering specialty centers,
the Grade Expectations! guide to education standards and thousands of
educational products, including both well-known brands and hard-to-find quality
offerings, for children aged infant through 12.
Results of Operations
Revenues. Revenues in 2001 and 2000 consisted of online sales of third-party
educational products and charges to customers for shipping. Also included in
revenues are online sales of SmarterKids.com's proprietary CD-ROM products,
which are offered on a limited basis. In the quarters ended March 31, 2001 and
2000, SmarterKids.com derived approximately 2% of its revenues from outside of
the United States. Revenues are recognized when the products are received by
customers and are net of promotional discounts, coupons and return allowances,
which are determined by historical trends of actual returns.
Revenues were $1.9 million and $1.5 million in the quarters ended March 31,
2001 and 2000, respectively. The increase in revenue in the quarter ended March
31, 2001 from the quarter ended March 31, 2000 resulted from increased purchases
from repeat customers and increased promotional efforts. SmarterKids.com began a
liquidation strategy of its year-end inventory, which included several
promotional events, in connection with introducing a new product mix in the
second quarter of 2001, and transferring fulfillment services to Earlychildhood
in March 2001.
Cost of revenues. Cost of revenues consists primarily of the cost of products
sold to customers and the cost of shipping products to SmarterKids.com's
customers. SmarterKids.com anticipates that its gross margins will fluctuate
from quarter to quarter depending on consumer preferences for its mix of
products. The cost of revenues was $1.9 million and $1.1 million in the quarters
ended March 31, 2001 and 2000, respectively. The increase in cost of revenues in
the quarter ended March 31, 2001 from the quarter ended March 31, 2000 was
principally attributable to an inventory liquidation strategy related to
introducing a new product mix in the second quarter 2001 and transferring
fulfillment services to Earlychildhood in March 2001. The decrease in gross
margin to negative 0.21% in the quarter ended 2001 from 25% in the quarter ended
2000 was a direct result of a liquidation strategy where SmarterKids.com held
several promotional events with lowered retail prices in order to reduce the
inventory on hand in connection with the outsourcing of SmarterKids.com's
fulfillment services and the introduction of a new product mix in the second
quarter of 2001.
20
Marketing and sales. Marketing and sales expenses consist primarily of the
cost of advertising and promotional activities, fulfillment costs, commissions
to online marketing companies expenses for personnel engaged in marketing,
merchandising activities and stock compensation expense. Fulfillment costs
represent costs incurred in operating and staffing the distribution center and
the customer service department, picking and packing customers' orders for
shipment, responding to inquires from customers, credit card fees, as well as
fees paid to J.L. Hammett Co., a fulfillment partner during the first six months
of 2000. As of July 1, 2000, SmarterKids.com discontinued using J.L. Hammett Co.
as a third party fulfillment partner due to the opening of its own distribution
facility. As of March 31, 2001, SmarterKids.com transferred its fulfillment to
Earlychildhood in connection with the Combination.
Marketing and sales expenses were $3.8 million and $7.6 million in the
quarters ended March 31, 2001 and 2000, respectively. Included in marketing and
sales expenses were stock compensation expenses of $204,000 and $309,000 for the
quarter ended March 31, 2001 and 2000, respectively. The decrease in the
quarter ended March 31, 2001 from the quarter ended March 31, 2000 was primarily
attributable to decreased advertising and promotional activities and a reduction
of headcount related to SmarterKids.com restructuring plan adopted in the fourth
quarter of 2000. Fulfillment costs included in marketing and sales expense were
$1.1 million in each of the quarters ended March 31, 2001 and 2000.
In September 2000, the Emerging Issues Task Force (EITF) reached a final
consensus on EITF Issue 00-10, "Accounting for Shipping and Handling Fees and
Costs." This consensus states that all amounts billed to a customer in a sale
transaction related to shipping and handling, if any, represent revenue and
should be classified as revenue. SmarterKids.com classifies shipping charges to
customers as revenue. With respect to the classification of costs related to
shipping and handling incurred by the seller, including fulfillment costs, the
EITF determined that the classification and amount of such costs is an
accounting policy decision that should be disclosed. SmarterKids.com classifies
fulfillment costs as marketing and sales expenses. These costs are primarily
composed of distribution facility expenses, including equipment and supplies,
payroll and travel expenses for personnel engaged in distribution activities,
third party fulfillment fees, credit card fees and the costs of customer
support. These costs represent facility costs necessary for warehousing
inventory, as well as costs incurred to pick and pack a customer order and the
related packaging supplies.
Development. Development expenses consist primarily of payroll and related
costs for personnel performing website design, development, maintenance and
testing. Development expenses were $823,000 and $662,000 in the quarters ended
March 31, 2001 and 2000, respectively. Included in development costs were stock
compensation expenses (credits) of $49,000 and ($281,000) for the quarters ended
March 31, 2001 and 2000, respectively. The decrease in the quarter ended March
31, 2001 from the quarter ended March 31, 2000 was attributable primarily to
reduced overhead allocations.
General and administrative. General and administrative expenses consist
primarily of payroll and related costs for executive and administrative
personnel, professional service expenses and other general corporate expenses.
General and administrative expenses were $812,000 and $1,056,000 in the quarters
ended March 31, 2001 and 2000, respectively. Included in general and
administrative expenses were stock compensation expenses of $316,000 and
$150,000. The decrease in the quarter ended March 31, 2001 from the quarter
ended March 31, 2000 was attributable primarily to reductions in headcount
related to SmarterKids.com's restructuring plan adopted in the fourth quarter of
2000.
Stock compensation. With respect to stock options granted to employees,
SmarterKids.com recorded non-cash stock compensation expense of $569,000 and
$178,000 in the quarters ended March 31, 2001 and 2000, respectively, related to
amortization of deferred stock compensation for options and warrants granted to
employees and non-employees and, with respect to first quarter 2001 the
acceleration of vesting on certain employee options. For non-employee grants,
the compensation charge reflects the fair value of the options and warrants on
the initial measurement date (typically the date of grant for those exercisable
immediately or with fixed vesting periods, or the date when vesting becomes
fixed for those with variable vesting periods), as well as subsequent re-
measurements of such fair value until the options and warrants vest.
Accordingly, SmarterKids.com cannot currently estimate additional charges
related to future re-measurement of unvested non-employee options and warrants.
21
On September 7, 2000, SmarterKids.com completed a direct repricing of certain
employee stock option grants. As part of the repricing, SmarterKids.com
reduced the exercise price of all outstanding options with exercise prices of
greater than $1.50 per share. The new exercise price of these repriced options
was reset to $1.50 per share, which was equal to the market value of the common
stock on September 7, 2000. Options to purchase 2,325,574 shares of
SmarterKids.com common stock were repriced. SmarterKids.com is accounting for
the repriced options as a variable award. In the quarter ended March 31, 2001,
SmarterKids.com did not record any additional non-cash stock compensation
charges as a result of this repricing since the market price of the common stock
at March 31, 2001 was less than the repriced exercise price.
Restructuring charges. During the fourth quarter of 2000, SmarterKids.com
approved and implemented a restructuring program in order to reduce operating
expenses. The restructuring plan is expected to be completed by June 2001. The
program included a net reduction of 60% of its workforce. Accordingly, during
the fourth quarter of 2000, SmarterKids.com recorded a charge of $1.3 million
related to employee termination benefits. During the first quarter of 2001,
SmarterKids.com recorded additional restructuring charges of $2.3 million
related to the closing of its warehouse and transfer of fulfillment operations
to Earlychildhood. As of March 31, 2001, $540,000 has been paid out and $3.1
million remains accrued.
Interest Income and Expense, Other Income and Expense. Interest income
consists primarily of interest earned on capital invested in commercial paper
and corporate and treasury notes. Interest expense is related to short-term
lease obligations and borrowings under SmarterKids.com's equipment lines of
credit. Also included in other expense in the quarter ended March 31, 2001 are
transaction expenses related to the proposed combination with Earlychildhood.
The transaction expenses consist primarily of legal, accounting and investment
banking fees. Interest and other income (expense), net decreased to ($781,000)
in the quarter ended March 31, 2001 from $828,000 in the quarter ended March 31,
2000. The decrease was primarily attributable to a decrease in interest income
due to decreased levels of cash, cash equivalents and short-term investments and
to transaction expenses of $1.2 million.
Liquidity and Capital Resources
Since its inception, SmarterKids.com has incurred significant losses.
SmarterKids.com has met its cash requirements primarily through the sale of
capital stock and the use of lines of credit and capital leases. SmarterKids.com
has received capital from investors in three private venture capital financings
totaling $37.0 million through July 1999. On November 23, 1999, SmarterKids.com
completed an initial public offering of 4,500,000 shares of common stock,
resulting in net proceeds of $65.9 million. The primary purposes of the initial
public offering were to increase SmarterKids.com's capitalization and financial
flexibility, create a public market for SmarterKids.com's common stock, and
facilitate future access to public markets. As of March 31, 2001,
SmarterKids.com had used $40.8 million of the offering proceeds for working
capital.
Net cash used in operating activities was $5.9 million and $16.2 million in
the three months ended March 31, 2001 and 2000, respectively. The decrease in
net cash used in operating activities from the three months ended March 31, 2000
to the three months ended March 31, 2001 was primarily attributable to the
reduction of operating expenses in connection with SmarterKids.com's
restructuring initiatives. SmarterKids.com expects that operating cash
requirements will decrease as the savings from the restructuring plan takes
further effect.
Net cash provided by investing activities was primarily a result of the sale
of short-term investments. Net cash used in investing activities in the three
months ended March 31, 2000 was primarily for purchases of fixed assets and
short-term investments. Cash provided in investing activities was $12.5 million
in the three months ended March 31, 2001. Cash used in investing activities was
$23.4 million in the three months ended March 31, 2000.
Net cash used by financing activities was $103,000 in the three months ended
March 31, 2001. Net cash provided by financing activities was $976,000 in the
three months ended March 31, 2000. Net cash used by
22
financing activities in the three months ended March 31, 2001 primarily reflects
the repayment of long-term borrowings. Net cash provided by financing activities
in the three months ended March 31, 2000 primarily consisted of net proceeds of
$1.3 million from an equipment line of credit.
During the first quarter of 2000, SmarterKids.com entered into a $1.5 million
three-year equipment line of credit facility. Equipment collateralized under
this agreement approximates $965,000 at March 31, 2001. The interest on the
agreement is equal to the three-year U.S. Treasury rate plus 3.5%.
SmarterKids.com is making payments on this credit facility of $45,000 per month.
As of April 30, 2001, the balance of the equipment credit facility was paid in
full.
During the second quarter of 2000, SmarterKids.com entered into a lease
agreement for a 140,000 square foot distribution center in Mansfield,
Massachusetts. As a result, SmarterKids.com discontinued using J.L. Hammett Co.
as its fulfillment partner during the second quarter of 2000. The five-year
operating lease for the warehouse will require minimum payments of approximately
$900,000 per year. The warehouse lease was terminated as of April 30, 2001 in
connection with the restructuring plan extended in the first quarter of 2001. As
of March 31, 2001, fulfillment services were outsourced to Earlychildhood.
As of March 31, 2001, SmarterKids.com had $24.0 million of cash and cash
equivalents and $1.1 million of short-term investments. As of that date,
SmarterKids.com's principal commitments consisted of obligations outstanding
under an equipment lines of credit and capital leases in the amount of $1.1
million, commitments for annual facility lease obligations of $3.0 million, and
accounts payable of $2.7 million.
SmarterKids.com anticipates that current cash, cash equivalents and short-term
investments will be sufficient to meet its anticipated needs for working capital
and capital expenditures through the next twelve months either on a stand-alone
basis or in combination with Earlychildhood.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities," as amended by SFAS No. 137,
which was issued in June 2000. SmarterKids.com adopted SFAS No. 133 on January
1, 2001. SFAS No. 133 requires that all derivative instruments be reported on
the balance sheet at their fair value. Changes in the fair value of derivatives
are recorded each period in current earnings or other comprehensive income,
depending on whether a derivative is designated as part of a hedge transaction
and, if it is, the type of hedge transaction. The adoption of SFAS No. 133 had
no impact on SmarterKids.com's financial condition, results of operations, or
business practices.
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ITEM 6. EXHIBIT AND REPORTS ON FORM 8-K
(a) Exhibit.
The following Exhibit is filed herewith:
Exhibit 99.1 Risk Factors
(b) Reports on Form 8-K.
None.
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SIGNATURE
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, as amended, the Registrant has duly caused this report to be signed
on its behalf by the undersigned thereunto duly authorized in Monterey,
California on the 15th day of May 2001.
LEARNINGSTAR CORP.
By: /s/ Robert J. Cahill
--------------------------
Robert J. Cahill
Chief Financial Officer
(Duly Authorized Officer and
Principal Financial Officer)
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Exhibit Index to Report on Form 10-Q
for Quarter Ended March 31, 2001
Exhibit No. Exhibit
- ----------- -------
99.1 Risk Factors
26