UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 20-F
(MARK ONE)
[ ] REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE
SECURITIES EXCHANGE ACT OF 1934
OR
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED MAY 31, 2002
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: 0-31112
VHQ ENTERTAINMENT INC.
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(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CANADA
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(JURISDICTION OF INCORPORATION OR ORGANIZATION)
6201 - 46TH AVENUE, RED DEER, ALBERTA T4N 6Z1
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(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
SECURITIES REGISTERED OR TO BE REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
NONE
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SECURITIES REGISTERED OR TO BE REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON SHARES
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(TITLE OF CLASS)
SECURITIES FOR WHICH THERE IS A REPORTING OBLIGATION PURSUANT TO SECTION 15(d)
OF THE ACT:
NOT APPLICABLE
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(TITLE OF CLASS)
INDICATE THE NUMBER OF OUTSTANDING SHARES OF EACH OF THE ISSUER'S CLASSES OF
CAPITAL OR COMMON STOCK AS OF:
May 31, 2002: 12,306,803 Common Shares
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
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Indicate by check mark which financial statement item the registrant has elected
to follow.
Item 17 X Item 18
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TABLE OF CONTENTS
PAGE
ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISORS...............2
ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE.............................2
ITEM 3. KEY INFORMATION.....................................................2
ITEM 4. INFORMATION ON THE COMPANY.........................................16
ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS.......................34
ITEM 6. DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES.........................51
ITEM 7. MAJORITY SHAREHOLDERS AND RELATED PARTY TRANSACTIONS...............66
ITEM 8. FINANCIAL INFORMATION..............................................71
ITEM 9. LISTING............................................................72
ITEM 10. ADDITIONAL INFORMATION.............................................73
ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET
RISKS..............................................................88
ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES.............88
ITEM 13 DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES....................88
ITEM 14 MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS
AND USE OF PROCEEDS................................................88
ITEM 15 CONTROLS AND PROCEDURES............................................89
ITEM 16 [RESERVED].........................................................89
ITEM 17. FINANCIAL STATEMENTS...............................................89
ITEM 18. FINANCIAL STATEMENTS...............................................89
ITEM 19. EXHIBITS...........................................................89
1
NOTE REGARDING FORWARD LOOKING STATEMENTS
Except for statements of historical fact, certain information contained herein
constitutes "forward-looking statements," including, without limitation,
statements containing the words "believes," "anticipates," "intends," "expects"
and words of similar import, as well as all projections of future results. Such
forward-looking statements involved known and unknown risks, uncertainties and
other factors which may cause the actual results or achievements of the Company
to be materially different from any future results or achievements of the
Company expressed or implied by such forward-looking statements. Such factors
include, among others, the following: the Company's limited operating history,
the Company's need for additional financing to expand its business, the
competition in the movie video and video game industry, technological change in
the video industry that may adversely affect the Company's business, the
Company's dependence on key officers and employees, the Company's reliance on
third-party providers of video entertainment and video games, the Company's
ability to integrate new stores into its operations and to manage growth, the
seasonality of the video entertainment industry, and other factors described
under "Item 3. Key Information - Risk Factors" in this annual report.
December 13, 2002
i
ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISORS
Not applicable.
ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE
Not applicable.
ITEM 3. KEY INFORMATION
SELECTED FINANCIAL DATA
The following table sets forth selected financial data regarding our
consolidated operating results and financial position. The data has been derived
from our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in Canada ("Canadian
GAAP"). For reconciliation to accounting principles generally accepted in the
United States see the captions under the May 31, 1999, May 31, 2000, May 31,
2001, and May 31, 2002 columns. The following selected financial data is
qualified in its entirety by, and should be read in conjunction with, the
consolidated financial statements and notes thereto included elsewhere in this
annual report. The selected financial data is expressed in Canadian dollars (in
accordance with Canadian GAAP).
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ALL FIGURES IN ($ CAD)
<table>
<caption>
THE TWELVE THE TWELVE THE TWELVE THE TWELVE ONE MONTH THE TWELVE
MONTH PERIOD MONTH PERIOD MONTH PERIOD MONTH PERIOD ENDED MAY 31, MONTHS ENDED
ENDED ENDED MAY ENDED ENDED MAY 31, 1998 APRIL 30, 1998
MAY 31, 2002 31, 2001 MAY 31, 2000 1999
(Audited) (Audited) (Audited) (Audited)
<s>
REVENUE 26,114,173 $21,330,467 $12,884,852 $4,919,535 $217,632 $1,087,674
GROSS MARGIN 13,965,521 13,293,605 8,620,422 3,189,942 143,879 408,416
TOTAL OPERATING 13,990,192 12,052,194 7,728,628 2,791,188 146,931 443,087
COSTS & EXPENSES
OPERATING INCOME
(LOSS)
Cdn GAAP 24,671 1,241,411 891,794 398,754 (3,052) (34,671)
US GAAP (428,671) (1,859,456) (621,236) 398,754 N/A N/A
NET INCOME (LOSS)
Cdn GAAP (2,349,289) (2,813,521) 2,102,867 217,383 (3,567) (38,408)
US GAAP 517,510 (4,495,956) (827,410) 217,383 N/A N/A
NET INCOME (LOSS) .
PER SHARE
Cdn GAAP (0.20) $(.24) 0.21 0.03 0 (.01)
US GAAP 0.04 (.42) (.09) 0.03 N/A N/A
NUMBER OF SHARES
USED TO CALCULATE
EARNINGS (LOSS)
PER SHARE:
Cdn GAAP 11,903,465 11,490,281 10,086,383 7,294,697 5,200,000 7,200,000
US GAAP 11,737,724 10,768,281 8,956,383 6,511,720 N/A N/A
DIVIDENDS 0 0 0 0 0 0
DECLARED PER
SHARE
</table>
3
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$CAD
<table>
<caption>
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AT AT AT AT AT AT
MAY 31, 2002 MAY 31, 2001 MAY 31, 2000 MAY 31, 1999 MAY 31, 1998 APRIL 30, 1998
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<s>
CASH $ 121,145 $155,371 $238,635 $229,504 $272,519 $655,698
WORKING CAPITAL (4,836,192) (2,859,075) (549,127) (182,719) (53,898) 398,569
(DEFICIENCY)
TOTAL ASSETS
Cdn GAAP 15,580,249 13,737,968 14,553,094 3,955,310 2,063,515 2,244,704
US GAAP 15,580,249 15,160,017 16,784,142 3,955,310 N/A N/A
TOTAL LIABILITIES
Cdn GAAP 9,355,981 6,646,715 6,187,053 1,115,732 533,490 461,919
US GAAP 8,607,981 9,152,258 7,855,161 1,115,732 N/A N/A
NET ASSETS
Cdn GAAP 6,224,268 7,091,253 8,366,041 2,839,578 1,530,025 1,782,785
US GAAP 6,972,268 6,007,759 8,928,982 2,839,578 N/A N/A
SHARE CAPITAL
Cdn GAAP 9,108,803 7,626,499 6,087,766 2,664,170 1,572,000 1,821,193
US GAAP 12,637,991 11,155,687 9,580,954 2,664,170 N/A N/A
LONG-TERM DEBT
Cdn GAAP 949,383 110,794 233,996 222,422 56,161 56,161
US GAAP 949,383 3,364,023 3,989,910 222,422 56,161 56,161
================================================================================================================================
</table>
CURRENCY AND EXCHANGE RATES
The following table sets forth the exchange rates for one Canadian dollar ("$")
expressed in terms of one United States dollar ("US$") in effect at the end of
the following periods, and the average exchange rates (based on the average of
the exchange rates on the last day of each month in such periods) and the range
of high and low exchange rates for such periods.
4
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<table>
<caption>
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THE TWELVE THE TWELVE THE TWELVE THE TWELVE THE TWELVE
MONTH MONTH PERIOD MONTH PERIOD MONTH PERIOD MONTH PERIOD
PERIOD ENDED MAY 31, ENDED ENDED MAY 31, ENDED MAY 31,
ENDED MAY 2001 MAY 31, 2000 1999 1998
31, 2002
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<s> <c> <c> <c> <c> <c>
END OF PERIOD 0.6266 0.6468 0.6677 0.6791 0.6863
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AVERAGE FOR THE 0.6383 0.6596 0.6792 0.6616 0.7064
PERIOD
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HIGH FOR THE PERIOD 0.6622 0.6831 0.6969 0.6891 0.7305
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LOW FOR THE PERIOD 0.6200 0.6333 0.6607 0.6341 0.6832
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</table>
<table>
<caption>
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U.S. DOLLARS PER CANADIAN DOLLAR
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OCTOBER SEPTEMBER AUGUST JULY JUNE MAY
2002 2002 2002 2002 2002 2002
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<s> <c> <c> <c> <c> <c> <c>
HIGH FOR THE MONTH 0.6407 0.6433 0.6442 0.6603 0.6619 0.6547
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LOW FOR THE MONTH 0.6272 0.6304 0.6264 0.6297 0.6452 0.6452
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</table>
Exchange rates are based upon the noon buying rate in New York City for cable
transfers in foreign currencies as certified for customs purposes by the Federal
Reserve Bank of New York. The noon rate of exchange on October 31, 2002 as
reported by the United States Federal Reserve Bank of New York for the
conversion of Canadian dollars into United States dollars was Cdn$1.5610 =
US$1.00; Cdn$1.00 = US$0.6406. Unless otherwise indicated, in this annual report
all references herein are to Canadian Dollars.
RISK FACTORS
Our securities are highly speculative. It is important to consider that we are
in the growth stage of our operations as an operator of video and home
entertainment stores. Described below are specific risks that are associated
with our business.
COMPANY SPECIFIC RISKS
WE HAVE A HISTORY OF RECENT LOSSES AND WE MAY INCUR LOSSES IN FUTURE PERIODS.
As of May 31, 2002, our retained deficit was $2,884,535. We reported net losses
of $2,349,289 for the fiscal year ended May 31, 2002, and $2,813,521 for the
fiscal year ended May 31, 2001. Our operating expenses and marketing expenses
have increased continuously since inception and we expect them to continue to
increase significantly in the next several years as we implement our growth
strategy and expand our business. As a result, we anticipate that we will need
to increase our revenues to achieve profitability. In order to increase our
revenues, our stores must remain competitive and we must maintain continued
growth in same store sales and generate expected sales from new stores. If our
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revenues do not increase as much as we expect or if our expenses increase at a
greater pace than revenues, we may not be able to sustain or increase
profitability on a quarterly or annual basis.
WE HAVE AND WILL CONTINUE TO OPERATE WITH A NEGATIVE WORKING CAPITAL DEFICIT.
At May 31, 2002, we had a working capital deficit of $4.8 million compared to
$2.89 million as at May 31, 2001. The working capital deficit results from the
accounting treatment of our rental inventory. Rental inventory is treated as a
capital asset rather than a current asset under Canadian GAAP because it is a
depreciable asset and is not an asset that is reasonably expected to be
completely realized in cash or sold in the normal business cycle. Although the
rental of this inventory generates a major portion of our revenue, the
classification of this asset as non-current results in its exclusion from
working capital. The aggregate amount payable for this inventory, however, is
reported as a current liability until paid and, accordingly, is included in
working capital. As a result, we do not believe that working capital is an
appropriate measure of our liquidity and anticipate that we will continue to
operate with a working capital deficit.
WE HAVE A LIMITED OPERATING HISTORY, WHICH MAKES IT DIFFICULT TO PREDICT THE
FUTURE SUCCESS OF OUR OPERATIONS AND OUR INDIVIDUAL VIDEO AND HOME ENTERTAINMENT
STORES.
We have only a limited operating history upon which you can evaluate our
business and prospects. We entered into the retail video rental industry by
acquiring Integrated Retail Corp. in September 1998. Integrated Retail Corp. was
formed in 1997. See "Item 4. Information on the Company - Our Acquisitions".
Approximately 30% of our video and home entertainment stores are less than two
years old, which makes it difficult to predict the future success of each store.
You should consider our prospects in light of the risks, expenses and
difficulties we may encounter as an early stage company in a stage of rapid
growth through acquisition. These risks include:
o our ability to effectively integrate new stores into our
organization;
o the adverse effect that acquisition costs may have on the results
of our historical operations;
o competition, including increased competition, in the markets we
service;
o the adverse effect that our new stores or acquisitions may have on
the sales of our existing stores serving the same markets;
o our ability to attract and maintain quality personnel;
o general regional and national economic conditions;
o consumer trends related to video entertainment and home
entertainment;
o acceptance of our entertainment and product mix;
o timing of promotional events and product introductions; and
o our ability to execute our business strategy effectively.
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Comparable store sales may not increase at historical rates and operating costs
may increase in the future. Changes in our comparable store sales results could
cause the price of the common stock to fluctuate substantially.
TO DATE, MUCH OF OUR REVENUE GROWTH IS ATTRIBUTABLE TO THE OPENING OR
ACQUISITION OF NEW STORES. IF WE ARE NOT ABLE TO INCREASE REVENUE GROWTH AT
EXISTING STORES, WE MAY NOT BE ABLE TO INCREASE OR SUSTAIN REVENUE GROWTH ONCE
WE REACH A LOWER GROWTH STAGE.
The majority of our revenue growth since inception can be attributed to the
acquisition of new retail locations. Since inception, we have paid $3.19 million
in cash and issued an aggregate of 7,974,957 shares, warrants and options in
making such acquisitions. In order to sustain revenue growth as our acquisitions
decrease, we must increase the revenue of existing retail locations. If we fail
to increase existing store revenue, our results will suffer.
WE MAY BE UNABLE TO SUSTAIN OUR GROWTH OR TO MANAGE THE GROWTH OF OUR
OPERATIONS, WHICH MAY AFFECT OUR PROFITABILITY.
Our growth strategy includes the acquisition of existing video and home
entertainment stores and the opening of new stores. During the fiscal year
ending May 31, 2002, we opened four new stores. As of the date of this annual
report, we operate a total of 49 stores, compared to operating 45 stores as at
May 31, 2001, and 33 stores at May 31, 2000. In January 2003 we expect to open
our 50th store. Execution of our growth strategy requires our existing
management personnel to, among other things:
o identify acquisition candidates who are willing to sell their
businesses at reasonable prices;
o identify new sites where we can successfully compete and negotiate
acceptable leases to implement cost-efficient development plans
for new stores;
o obtain financing for acquisitions and new store development;
o hire, train and assimilate store managers and other store
personnel;
o hire and train additional product fulfillment personnel to handle
additional product distribution; and
o integrate each store's management information system and marketing
programs into our system.
Our growth could strain the ability of existing management to accomplish these
tasks and lessen the effectiveness of management with respect to existing
operations. We cannot assure you that we will successfully open new stores or
identify, negotiate, finance, consummate or assimilate the acquisition of
additional video and home entertainment stores in the future. Continued
substantial growth could have a material adverse effect on our results of
operations, while on the other hand, the failure to maintain our growth rate
could have a material adverse effect on the price of our common shares.
In addition to the management challenges, our future growth will require
significant capital. In the past, acquisitions and store openings have been
financed primarily with proceeds from our previous private
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and public offerings of common shares, debt and internally generated cash flow.
We may seek to raise additional capital through future public or private sales
of debt or equity securities. However, we cannot assure you that we can obtain
sufficient capital on reasonable terms, if at all, to implement our growth
strategy.
OUR BUSINESS STRATEGY REQUIRES THE OPENING OF, OR ACQUISITION OF, NEW RETAIL
LOCATIONS, BOTH OF WHICH ARE RESOURCE INTENSIVE, AND MAY REQUIRE US TO OBTAIN
ADDITIONAL FINANCING. IF WE FAIL TO OBTAIN SUCH FINANCING, WE MAY BE UNABLE TO
IMPLEMENT OUR BUSINESS STRATEGY AND OUR RESULTS MAY SUFFER.
Financing for the opening and acquisition of new stores may be in the form of
debt or equity or both and may not be available on terms acceptable to us, if at
all. We estimate that the average cash investment for tenant improvements,
inventory (net of payables), marketing and training required to open a new store
is between approximately $225,000 and $275,000 for our traditional store format.
We estimate the cost of opening a rebranded VHQ Entertainment store to be up to
approximately $275,000. The actual cost of opening a store may be significantly
greater than such current estimates. We may need to seek additional debt and/or
equity financing in order to fund our continued expansion through our fiscal
year ending May 31, 2003 and beyond. In addition, our ability to incur
indebtedness or issue equity or debt securities could be limited by risks
described throughout this Risk Factors section, including general economic risks
and risks affecting our business and results of operations; some of which are
beyond our control. Further, our issuance of equity securities to raise capital
to acquire or open additional stores may have the effect of diluting the
interests of our existing stockholders.
PIRACY OF THE PRODUCTS WE OFFER MAY ADVERSELY AFFECT OUR OPERATIONS.
With the advent of the Internet, the risk with respect to the access to pirated
motion picture products has increased. Traditionally, pirated VHS tapes could be
obtained on a black market, however, these tapes were of poor quality and the
distributors of the tapes could be shut down quickly since they could be located
as soon as they attempted to sell the pirated tapes. However, with the
development of the Internet, and its non-jurisdictional nature, there is now the
potential for wide distribution of pirated movies at a low cost. This poses a
threat to not only the producers and creators of motion pictures but to
entertainment providers like us.
Currently movie studios generate approximately 60% of their overall revenues
from non-theatrical resources (including retail and rental) and accordingly,
maintaining rights and control over their product distribution over the Internet
is fundamental to the ongoing profitability of the studios. We expect that the
movie industry will follow the music industry, which in the United States
recently challenged the sale of non-licensed music over the Internet. The
creators and owners of music were successful in stopping a significant web based
distributor of unlicensed music from continuing to sell their product. Like the
music industry, we believe the studios will take an aggressive position against
piracy over the Internet, since it is fundamental to profitability of the
studios to ensure that only licensed providers distribute their products. There
can be no guarantees, however, that the studios will take steps to enforce their
rights against Internet piracy or that they will be successful in preventing the
distribution of pirated movies.
IF WE DON'T RECEIVE ADDITIONAL FINANCING, WE WILL NOT BE ABLE TO EXECUTE OUR
BUSINESS PLAN.
We will require additional financing to execute our business plan. Our ability
to arrange such financing in the future will depend in part upon the prevailing
capital market conditions, as well as our business performance. There can be no
assurance that we will be successful in our efforts to arrange additional
8
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financing on satisfactory terms. If additional financing is raised by the
issuance of shares from treasury, control of our business may change and
shareholders may suffer additional dilution. If adequate funds are not
available, or are not available on acceptable terms, we may not be able to take
advantage of opportunities, develop new products or otherwise respond to
competitive pressures and remain in business.
ACQUISITION RISKS
Our growth strategy may involve the continued acquisition of existing video and
home entertainment stores. This strategy includes the following risks:
WE MAY BE UNABLE TO COMPETE WITH OTHER VIDEO CHAINS FOR ATTRACTIVE ACQUISITION
TARGETS, WHICH MAY LIMIT OUR GROWTH.
Some of our competitors may seek to acquire some of the same video and home
entertainment stores that we seek to acquire. This competition for acquisitions
would likely increase acquisition prices and related costs and result in fewer
acquisition opportunities, which could have a material adverse effect on our
growth or our ability to acquire acquisition targets on acceptable terms.
WE MAY BE UNABLE TO COMPETE WITH OTHER VIDEO CHAINS FOR ATTRACTIVE NEW STORE
LOCATIONS, WHICH MAY LIMIT OUR GROWTH.
Some of our competitors may seek to acquire some of the same video and home
entertainment new store locations that we seek to acquire. This competition for
new stores would likely increase new store acquisition prices and related costs
and result in fewer new store opening opportunities, which could have a material
adverse affect on our growth or our ability to open new stores on acceptable
terms.
SELLERS OF ACQUISITION TARGETS MAY MAKE MISREPRESENTATIONS TO US OR BREACH THE
TERMS OF AN ACQUISITION AGREEMENT, WHICH COULD ADVERSELY AFFECT THE VALUE OF AN
ACQUISITION.
Our acquisition of Family Video (our Saskatoon stores) was a stock acquisition,
subject to certain stated liabilities such as store leases. We acquired Rainbow
Video (our four original Calgary stores) by acquiring all of the stock of Safiqa
Holdings Ltd., and thereby the assets acquired are subject to all liabilities of
that entity, stated or otherwise. We acquired the Movies Plus stores by
acquiring all of the stock of 705556 Alberta Ltd., and thereby the assets
acquired are subject to all liabilities of that entity, stated or otherwise. In
completing each acquisition, we relied upon certain representations, warranties
and indemnities made by the sellers with respect to each of these acquisitions,
as well as our own due diligence investigations.
In the future, we may acquire additional video and home entertainment stores or
chains in either asset acquisitions or stock acquisitions. In either case, we
will rely upon certain representations, warranties and indemnities made by the
sellers with respect to each of these acquisitions and our due diligence. We
cannot assure you that the sellers' representations and warranties will be true
and correct or that our due diligence investigations will uncover all materially
adverse facts relating to the operations and financial condition of the acquired
businesses. In the event that we are required to pay for obligations not
expressly assumed, or which the seller, in connection with such acquisitions,
has not disclosed or in the
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event there are material misrepresentations, we may not be able to recoup the
costs of paying such obligations, or recover our damages, from the sellers.
WE ANTICIPATE THAT MOST POTENTIAL ACQUISITION TARGETS WILL BE PRIVATE COMPANIES
AND THAT WE WILL HAVE LIMITED KNOWLEDGE OF THEIR OPERATING HISTORIES, WHICH MAY
ADVERSELY AFFECT OUR ABILITY TO MAKE AN INFORMED ACQUISITION DECISION.
Notwithstanding our own due diligence investigations, our management will have
limited knowledge about the specific operating histories, trends and customer
buying patterns of the video and home entertainment stores that we seek to
acquire. Further, we anticipate that potential acquisition targets may have
limited operating histories, which could make predicting their future success
uncertain. Consequently, we cannot assure you that we will make acquisitions, if
any, at favorable prices, that acquired stores will perform as well as they have
performed historically or that we will have sufficient information to accurately
analyze the markets in which we elect to make acquisitions. Our failure to pay
reasonable prices for acquisitions or to acquire profitable video and home
entertainment stores could have a material adverse effect on our results of
operations.
OUR FAILURE TO INTEGRATE THE OPERATIONS OF VIDEO AND HOME ENTERTAINMENT STORES
THAT WE ACQUIRE WITH EXISTING STORES AND SYSTEMS MAY CREATE OPERATING
INEFFICIENCIES, WHICH COULD ADVERSELY AFFECT OUR RESULTS OF OPERATIONS.
The success of the video and home entertainment stores we acquire depends in
large part on our ability to integrate these stores into our purchasing,
marketing and management information systems. If we fail to integrate acquired
stores successfully and on a timely basis, we may not achieve operating
efficiencies and our results of operations may suffer. We currently operate
stores that we have acquired under different brand names, including the "Family
Video" name, and we may acquire and operate other video and home entertainment
stores under other brand names. Operating stores under different brand names
creates a challenge for our management and may diminish our operating
efficiencies. We anticipate that we will maintain the personnel and the general
business operations of the video and home entertainment stores we acquire. The
success of these acquisitions will be dependent, in part, upon the manner in
which we are able to integrate the personnel into our operations and the manner
in which the acquired stores were operated. We cannot assure you that we will be
able to integrate these existing video and home entertainment stores in a manner
consistent with our standards.
OPERATING RISKS
Our business is subject to operating risks associated with the home
entertainment industry and our operations. Set forth below are material risks
associated with the operation of our business.
THE VIDEO RETAIL AND HOME ENTERTAINMENT INDUSTRY IS HIGHLY COMPETITIVE AND SOME
OF OUR COMPETITORS HAVE SUBSTANTIALLY GREATER RESOURCES THAN US, WHICH THEY MAY
USE TO IMPLEMENT STRATEGIES THAT COULD ADVERSELY AFFECT OUR MARKET SHARE AND
RESULTS OF operations.
The home entertainment industry is highly competitive and there are few barriers
to entry. We compete with many other video and home entertainment stores,
including stores operated by regional and national chains, as well as other
businesses offering video cassettes and video games such as supermarkets,
pharmacies, convenience stores, bookstores, mass merchants, mail order
operations and other retailers. Some of our competitors may open locations in
close proximity to our video and home entertainment
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stores and may offer broader product selections, lower prices and better rental
terms than us, which may cause our customers to patronize our competitors. Some
of our competitors have greater financial and marketing resources, market share
and name recognition than us, which may allow them to quickly develop market
presence in the markets we serve or allow them to expand into new markets that
we intend to serve. We cannot assure you that we will be able to effectively
compete with these competitors.
In addition, we compete with all leisure-time activities, such as movie
theaters, network and cable television, direct broadcast satellite television,
live theater, sporting events and family entertainment centers. In the event the
demand for our products declines, our business and results of operations will be
adversely affected.
THE VIDEO ENTERTAINMENT PRODUCTS THAT WE OFFER ARE SUBJECT TO TECHNICAL
OBSOLESCENCE, WHICH COULD REDUCE THE DEMAND FOR THE PRODUCTS WE OFFER.
We compete with, among others, pay-per-view cable television systems
("Pay-Per-View"), in which subscribers pay a fee to see a movie that they
select. Pay-Per-View presently offers only a limited number of channels and
movies in certain cable television markets; however, recently developed
technologies permit certain cable companies, direct broadcast satellite
companies (such as DirecTV), telephone companies and other telecommunications
companies to transmit a much greater number of movies to homes throughout the
United States at frequent intervals (often as frequently as every five minutes)
throughout the day, referred to as "Near Video-on-Demand" ("NVOD"). NVOD does
not offer full interactivity or VCR functionality such as allowing the consumer
to control the playing of the movie, starting, stopping and rewinding.
Ultimately, further improvements in these technologies could lead to the
availability of a broad selection of movies to consumers on demand, referred to
as Video-on-Demand ("VOD"), at a price which may be competitive with the price
of video cassette rentals and with VCR functionality. Some cable and other
telecommunications companies have tested and are continuing to test limited
versions of NVOD and VOD, as well as premium digital cable channels in various
markets throughout Canada, the United States and Europe. Changes in the manner
in which movies are marketed, primarily related to an earlier release of movie
titles to NVOD and VOD distribution channels, could substantially decrease the
demand for video cassette rentals, which would have a material adverse effect on
our business. Currently, movie titles are released to the video and home
entertainment specialty store market from 30 to 120 days before release to the
Pay-Per-View (including NVOD and VOD) distribution channels.
THE DVD FORMAT IS EXPECTED TO GAIN POPULARITY WHICH WILL REQUIRE US TO MAKE
ADDITIONAL CAPITAL EXPENDITURES TO INCREASE OUR DVD SELECTION.
We anticipate that the popularity of movies recorded on DVDs will increase as
the price of DVDs become comparable with video cassettes. We currently offer a
selection of DVDs in all of our stores and anticipate that the selection will
grow as a percentage of the titles we offer. In the future, we may be required
to offer a broader selection of catalogue titles on DVD to remain competitive
and to meet the demands of the markets we serve. We anticipate that this may
require a substantial investment in DVD inventory, which may not be offset by
increased unit rentals. In addition, the advent of video compact discs may
result in consumers purchasing more films than in the past, which could have a
materially adverse effect on our rental volume and, as a result, on our profit
margins.
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VIDEO GAMING IS EXPECTED TO GAIN POPULARITY WITH CONSUMERS WHICH WILL REQUIRE US
TO MAKE ADDITIONAL CAPITAL EXPENDITURES TO INCREASE OUR VIDEO GAMING SELECTION
ON VARIOUS PLATFORMS.
We anticipate that video games will become increasingly popular with consumers,
as additional functionality and new games and features are promoted on various
platforms. We currently offer a selection of video games on most major
platforms, including Microsoft X-Box, Nintendo Game Cube and Sony Playstation in
all of our stores and we anticipate that the selection will continue to grow as
a percentage of the overall titles that we offer. In the future, we may be
required to offer both a broader selection and an increased number of new
release video games on all platforms in order to remain competitive and to meet
the demands of the markets we serve. We anticipate that this may require a
substantial investment in video game software, which may not be offset by
increased rentals.
THE VIDEO RENTAL INDUSTRY WOULD LOSE A SIGNIFICANT COMPETITIVE ADVANTAGE IF THE
MOVIE STUDIOS ADVERSELY CHANGE THEIR CURRENT DISTRIBUTION PRACTICES.
A significant competitive advantage that the video rental industry currently
enjoys over most other movie distribution channels, except theatrical release,
is the early timing of the video store distribution "window." This window is
exclusive against most other forms of non-theatrical movie distribution, such as
pay-per-view, premium television, basic cable and network and syndicated
television. The length of the window for movie rental varies, typically ranging
from 30 to 90 days for domestic video stores and from 120 to 180 days for
international video stores. Thereafter, movies are made sequentially available
to television distribution channels.
We could be materially adversely affected if:
- the video store windows were no longer the first following the theatrical
release;
- the length of the video store windows were shortened;
- the video store windows were no longer as exclusive as they are now; or
- an increasing number of titles were released to "sell-through" instead of
rental
because newly released movies would be made available earlier on other forms of
non-theatrical movie distribution. As a result, consumers would no longer need
to wait until after the video store distribution window to view a newly released
movie on other distribution channels and our business results might suffer.
OUR PRIMARY DEPENDENCE ON CERTAIN SUPPLIERS AND WHOLESALERS TO SUPPLY US WITH
INVENTORY MAY AFFECT OUR ABILITY TO OPERATE IN THE EVENT ANY SUCH SUPPLIER IS
UNABLE TO FULFILL OUR INVENTORY NEEDS ON REASONABLE TERMS.
Our continuing profitability depends in part on our ability to acquire
sufficient quantities of the latest and most popular titles (VHS cassettes,
DVDs, video games and music CDs) on a timely basis and at favorable prices. As
of October 31, 2002, we acquired approximately 40% of our supply of rental VHS
cassettes and DVDs, and substantially all of our video game products, from Video
One Ltd. The current contract with Video One is scheduled to expire on January
30, 2003 unless earlier renewed.
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While we believe that we can obtain comparable quantities of titles from other
suppliers, the number of alternative suppliers has diminished in recent years
due to the consolidation of the industry and the termination of our present
relationship with Video One could adversely affect our results of operation
until a suitable replacement is found. Also, we cannot guarantee that any such
replacement would provide service or payment terms as favorable as those
provided by Video One.
OUR OPERATIONS ARE SUBJECT TO SEASONAL AND OPERATING FLUCTUATIONS, WHICH MAY
AFFECT THE RESULTS OF OUR OPERATIONS.
Our video cassette, DVD and video game rental business is somewhat seasonal,
with revenues in April and May generally being lower due in part to the change
to Daylight Savings Time and improved weather, and revenues in September and
October generally being lower due in part to the start of school, the football
season and the new television season. The seasonality of our business could
adversely affect our financial results.
In addition, future operating results may be affected by many factors, including
variations in the number and timing of store openings, the timing of, and public
acceptance of new release titles available for rental and sale, the timing of
our acquisition of existing video and home entertainment stores, the extent of
competition, marketing programs, weather, special or unusual events, such as the
Olympics or a televised event of significant public interest, local organized
sports activities and other factors that may affect retailers in general. Any
concentration of new store openings and the related new store pre-opening costs
near the end of a fiscal quarter could have an adverse effect on the financial
results for that quarter.
BECAUSE MARGINS ON SELL-THROUGH PRODUCTS ARE LOWER THAN RENTAL MARGINS, OUR
MARGINS COULD BE MATERIALLY ADVERSELY AFFECTED IF A GREATER PROPORTION OF NEWLY
RELEASED MOVIES WERE INITIALLY PRICED AS A SELL-THROUGH PRODUCT AND CONSUMERS
DESIRED TO OWN THESE MOVIES RATHER THAN RENT THEM.
In general, studios initially price their movies at prices that are too high to
generate significant consumer demand for purchase. Recently, however, the
studios have released a limited number of movies at prices intended to generate
consumer demand to purchase these movies rather than rent them. This is referred
to as sell-through pricing. If studios release more movies at sell-through
prices, demand for video rentals may decrease and our results may be adversely
affected.
Sell-through retail margins are generally lower than rental margins. Some of our
competitors, such as mass merchandisers, warehouse clubs and Internet sites, can
distribute and sell these sell-through movies on VHS tape or DVD at lower costs
and/or may operate at lower margins than us. As a result, our sell-through
business has comprised only a small percentage of our total revenue. We believe
our profitability would be adversely affected if we did not derive most of our
revenues from the higher margin rental business. We could be materially
adversely affected if:
- a greater proportion of either release format were initially priced as
sell-through merchandise; and
- consumers desired to own, and not rent, these movies.
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WE HAVE A SIGNIFICANT AMOUNT OF FIXED COSTS AND, AS A RESULT, AN INCREASE IN
DOWNTIME OR DECREASE IN PRODUCTIVITY COULD RESULT IN OPERATING LOSSES.
Fixed costs, including costs associated with our premises and salaries, account
for a significant portion of our costs and expenses. As a result, downtime or
lost productivity resulting from lower demand, equipment failures or other
factors could result in operating losses for our business.
MANY OF THE COMMUNITIES IN WHICH HAVE STORES ARE DEPENDENT UPON A SINGLE OR A
FEW INDUSTRIES. IF ONE OR MORE OF THESE INDUSTRIES EXPERIENCES A DOWNTURN, THE
ECONOMIES OF THESE COMMUNITIES MAY EXPERIENCE A DOWNTURN WHICH COULD REDUCE THE
REVENUES FROM STORES IN ONE OR MORE OF THOSE COMMUNITIES.
We have developed a business strategy targeting the secondary retail markets
located in communities with a minimum trading area population of approximately
5,000 to 10,000 people. The strength of the local economy in these types of
communities typically depends upon the strength of a smaller number of key
industries. If the major sustaining industry in one of these communities is
negatively affected, the strength of the entire local economy will be negatively
affected and the amount of disposable income of the residents in that particular
community will decrease. Consequently, a store operated by us in that location
may be negatively affected.
COMPANY AND SECURITIES RELATED RISKS
WE DEPEND ON THE EXPERTISE OF KEY PERSONNEL. IF ANY OF THESE INDIVIDUALS WERE TO
LEAVE, OUR BUSINESS MAY SUFFER.
Our future success depends on the continued services of certain key management
personnel, including Trevor M. Hillman, our Chairman and Chief Executive
Officer, Gregg C. Johnson, our President and Chief Operating Officer, Derrek R.
Wong, our Senior Vice President of Finance and Chief Financial Officer and
Michael D. McKelvie, our Senior Vice President, Marketing & Communications. The
loss of any one of these individuals could have a material adverse effect on our
results of operations. We maintain key-man life insurance for Trevor M. Hillman.
We have entered into consulting agreements with Mr. Hillman and Mr. Johnson. To
date we have not entered into written employment agreements with Mr. Wong or Mr.
McKelvie. Our continued growth and profitability also depend on our ability to
attract and retain other management personnel, including qualified store
managers.
OUR CHAIRMAN AND CHIEF EXECUTIVE OFFICER, TREVOR M. HILLMAN, BENEFICIALLY
CONTROLS APPROXIMATELY 16.23% OF OUR COMMON SHARES AND OUR OFFICERS AND
DIRECTORS AS A GROUP CONTROL 49.07%, AND AS A RESULT, CAN INFLUENCE THE CONTROL
OF OUR COMPANY.
As of November 30, 2002, Trevor M. Hillman beneficially controlled approximately
16.33% of our issued and outstanding common shares, and our Directors and
officers, as a group, beneficially controlled approximately 49.07% of our common
shares. As a result, these stockholders, if acting together, would be able to
effectively influence control matters requiring approval by our stockholders,
including the election of all members of the Board of Directors and significant
corporate transactions, such as mergers or other business combinations. This
control may delay, deter or prevent a third party from acquiring or merging with
us, which in turn could reduce the market price of our common stock.
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OUR PRESIDENT AND CHIEF OPERATING OFFICER, GREGG C. JOHNSON, BENEFICIALLY
CONTROLS APPROXIMATELY 9.22% OF OUR COMMON SHARES AND OUR OFFICERS AND DIRECTORS
AS A GROUP CONTROL 49.07% AND AS A RESULT, CAN INFLUENCE CONTROL OF OUR COMPANY.
As of November 30, 2002, Gregg C. Johnson beneficially controlled approximately
9.22% of our issued and outstanding common shares, and our officers and
Directors, as a group, beneficially controlled approximately 49.07% of our
common shares. As a result, the stockholders, if acting together, would be able
to effectively influence control matters requiring approval by our stockholders,
including the election of all members of the Board of Directors and significant
corporate transactions, such as mergers or other business combinations. This
control may delay, deter or prevent a third party from acquiring or merging with
us, which in turn could reduce the market price of our common stock.
WE ARE A FOREIGN CORPORATION AND ALL OF OUR DIRECTORS AND OFFICERS ARE OUTSIDE
OF THE UNITED STATES, WHICH MAY MAKE ENFORCEMENT OF CIVIL LIABILITIES DIFFICULT.
We incorporated under the laws of Canada. As of October 31, 2002, all of our
Directors and officers are residents of Canada, and substantially all of our
assets are located outside of the United States. Consequently, it may be
difficult for United States investors to effect service of process within the
United States upon our Directors or officers, or to realize in the United States
upon judgments of United States courts predicated upon civil liabilities under
the United States Securities Exchange Act of 1934, as amended. A judgment of a
United States court predicated solely upon such civil liabilities would probably
be enforceable in Canada by a Canadian court if the United States court in which
the judgment was obtained had jurisdiction, as determined by the Canadian court,
in the matter. There is substantial doubt whether an original action could be
brought successfully in Canada against any of such persons or the Company
predicated solely upon such civil liabilities.
WE HAVE RESERVED UP TO 2,352,000 COMMON SHARES FOR FUTURE ISSUANCE AS STOCK
OPTIONS AND 389,819 COMMON SHARES FOR ISSUANCE UPON THE EXERCISE OF EXISTING
WARRANTS, WHICH IF ISSUED MAY CAUSE DILUTION IN THE VALUE OF CURRENTLY ISSUED
AND OUTSTANDING SHARES.
As of November 30, 2002, we have granted incentive stock options to Directors,
officers and key employees exercisable to acquire up to 1,627,300 common shares
and issued warrants which are exercisable to acquire up to 705,074 common
shares. Such options and warrants, if fully exercised, would constitute
approximately 18.6% of our common share capital at November 30, 2002. The
exercise of such options and the subsequent resale of such common shares into
the public market could adversely affect the prevailing market price and our
ability to raise equity capital in the future at a time and price which we may
deem appropriate. We may also enter into commitments in the future which would
require us to issue additional common shares and we may grant additional share
purchase warrants and stock options.
BROKER-DEALERS MAY BE DISCOURAGED FROM EFFECTING TRANSACTIONS IN OUR SHARES
BECAUSE THEY ARE CONSIDERED PENNY STOCKS AND ARE SUBJECT TO THE PENNY STOCK
RULES.
Rules 15g-1 through 15g-9 promulgated under the Securities Exchange Act of 1934,
as amended, impose sales practice and disclosure requirements on NASD
brokers-dealers who make a market in "a penny stock". A penny stock generally
includes any non-NASDAQ equity security that has a market price of less than
US$5.00 per share. Since July 24, 2001 our shares have been listed and posted
for trading on the Toronto Stock Exchange, the TSX. Prior to this, our shares
were listed on the Canadian Venture
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Exchange, the CDNX. The high and low closing price of our shares during 1999
ranged from $2.50 (high) to $0.50 (low), between $5.25 (high) and $1.85 (low)
during 2000, between $3.50 (high) and $1.65 (low) during 2001 and between $2.30
(high) and $0.38 (low) during the period from January 1, 2001 and October 31,
2002. The price of our shares on October 31, 2002 was $0.70.
Under the penny stock regulations, a broker-dealer selling penny stock to anyone
other than an established customer or an "accredited investor" (generally, an
individual with net worth in excess of US$1,000,000 or an annual income
exceeding US$200,000, or US$300,000 together with his or her spouse) must make a
special suitability determination for the purchaser and must receive the
purchaser's written consent to the transaction prior to sale, unless the
broker-dealer or the transaction is otherwise exempt. In addition, the penny
stock regulations require the broker-dealer to deliver, prior to any transaction
involving a penny stock, a disclosure schedule prepared by the SEC relating to
the penny stock market, unless the broker-dealer or the transaction is otherwise
exempt. A broker-dealer is also required to disclose commissions payable to the
broker-dealer and the registered representative and current quotations for the
securities. Finally, a broker-dealer is required to send monthly statements
disclosing recent price information with respect to the penny stock held in a
customer's account and information with respect to the limited market in penny
stocks. Our shares would be considered a penny stock. The additional sales
practice and disclosure requirements imposed upon brokers-dealers may discourage
broker-dealers from effecting transactions in our shares, which could severely
limit the market liquidity of the shares and impede the sale of our shares in
the secondary market.
ITEM 4. INFORMATION ON THE COMPANY
HISTORY AND DEVELOPMENT OF VHQ ENTERTAINMENT INC.
We, VHQ Entertainment Inc., were incorporated as 753541 Alberta Ltd., an Alberta
corporation under the BUSINESS CORPORATIONS ACT (Alberta) on September 5, 1997.
Our authorized capital consisted of an unlimited number of common shares.
On December 11, 1997, we issued 2,000,000 common shares to our founding
shareholders for aggregate consideration of $100,000. On December 22, 1997, we
amended our Articles of Incorporation to change our name to Video Headquarters
Inc. and to create a new class of an unlimited number of preferred shares
issuable in series.
In March 1998, we completed an initial public offering as a "Junior Capital Pool
Company" under the rules of the Alberta Securities Commission and The Alberta
Stock Exchange. A Junior Capital Pool Company is a company with no identified
business, which is formed and capitalized for the purposes of identifying
business opportunities. In our initial public offering, we issued 2,000,000
common shares at $0.10 per share for gross proceeds of $200,000. Our common
shares were listed and posted for trading on the junior capital pool board of
The Alberta Stock Exchange on June 9, 1998.
Effective September 18, 1998, we acquired all of the issued and outstanding
securities of Integrated Retail Corp. See "Our Acquisitions - Our Acquisition of
Integrated Retail". We also amended our Articles of Incorporation to consolidate
our common shares on a two (2) shares for one (1) share basis, so that after
giving effect to the consolidation and our acquisition of Integrated Retail
Corp, our issued and outstanding common shares amounted to 7,200,000 common
shares. Our acquisition of Integrated
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Retail Corp. constituted a "major transaction" under the rules of the Alberta
Securities Commission. As such, we were no longer classified as a Junior Capital
Pool Company and our shares were listed for trading on The Alberta Stock
Exchange. In November 1999, The Alberta Stock Exchange merged with the Vancouver
Stock Exchange to become the Canadian Venture Exchange (the "CDNX"). Our common
shares were traded on the CDNX under the trading symbol "VHQ" from November 1999
to July 30, 2001 at which time we voluntarily delisted our shares from the CDNX
as a result of the listing of our shares on the Toronto Stock Exchange ("TSX").
On July 24, 2001 our common shares commenced trading on the TSX.
At our November 22, 2000 annual meeting of shareholders, our shareholders
approved, among other items, the filing of Articles of Continuance under the
Canada Business Corporations Act and the changing of our name to "VHQ
Entertainment, Inc." from "Video Headquarters Inc.". The Certificate of
Continuance under the Canadian Business Corporations Act ("CBCA") was issued on
December 1, 2000. Also at the November 15, 2001 special and annual meeting of
shareholders, Trevor H. Hillman, Peter Lacey, Gregg C. Johnson, Catherine J.
McDonough, Ayaz Kara, Lorn Becker and Marc Gignac were elected to the Board of
Directors to serve one-year terms expiring at the next annual meeting of
shareholders. On June 5, 2002 we accepted the resignation of Lorne Becker and
Ayaz Kara as directors.
Since our inception (September 5, 1997) to May 31, 2002, our principal capital
expenditures and divestitures (including interests in other companies) were
approximately $22.14 million. Information concerning principal capital
expenditures and divestitures, since inception and currently planed are further
described under "Our Acquisitions", below, and "Item 5. Operating and Financial
Review and Prospects". We have not been subject to any bankruptcy, receivership
or similar proceedings.
Save and except for a written expression of interest to acquire all of the
assets of the Company by Video Update Inc. (a wholly-owned subsidiary of Movie
Gallery Inc. NASDAQ: MOVI), dated December 10, 2001; subsequent to which no
further discussions or negotiations have been undertaken, we have not had
indications of any public takeover by third parties with respect to our shares
and have not and do not intend to engage in any public takeovers of third
parties since our inception and during the current fiscal year.
Our principal business office is located at 6201 - 46th Avenue, Red Deer,
Alberta, T4N 6Z1, and our registered office is located at 1900, 715 - 5th
Avenue, S.W., Calgary, Alberta, T2P 2X6. Our phone number is (403) 346-8119 and
our e-mail address is www.mail@vhq.ca.
Our website is located at WWW.VHQ.CA. Information contained on our website is
not part of this Registration Statement.
BUSINESS OVERVIEW
As at the date of this annual report we operate a chain of 49 retail video and
home entertainment stores in Western Canada and the North West Territories. We
expect to open our 50th store in January 2003. Our business strategy is to focus
on serving in rural and secondary markets and smaller urban centers, which
typically have less competition, lower fixed costs and lower staffing costs. We
intend to grow by opening new stores using our video and home entertainment
store format that we have developed and by acquiring existing video and home
entertainment stores in the market that we target to serve. We intend to first
complete our expansion throughout Western Canada by the end of 2004, and
thereafter, we intend to expand into Eastern Canada following a similar
strategy. Although small rural and secondary markets
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in the United States are demographically similar to those in Canada, we do not
intend to pursue expansion into the United States until we have completed to a
significant degree, our current Canadian expansion likely in 2006.
The Company's capital expenditures, which relates mainly from the purchase of
rental assets and acquisitions, are as follows:
<table>
<caption>
- --------------------------------------------------------------------------------------------------------------
12 MONTHS ENDING 12 MONTHS ENDING 12 MONTHS ENDING 12 MONTHS ENDING
MAY 31, 2002 MAY 31, 2001 MAY 31, 2000 MAY 31, 1999
- --------------------------------------------------------------------------------------------------------------
<c> <c> <c> <c>
$6,584,005 $6,972 million $7,950 million $2.767 million
- --------------------------------------------------------------------------------------------------------------
</table>
Information concerning our principal capital expenditures and divestitures,
since inception and currently planned, are further described under "Our
Acquisitions" and "Item 5. Operating and Financial Review".
VIDEO AND ENTERTAINMENT INDUSTRY
We are engaged primarily in the rental and sale of filmed entertainment in VHS
and DVD format and related merchandise, the rental and sale of video games and
related accessories and the sale of music. The products we rent or sell are
generally within the "home entertainment" market. According to the Video
Software Dealers Association ("VSDA")U.S. consumers spent US $17.4 billion
renting and buying prerecorded video in 1999, up 2.4% from expenditures in1998.
Video spending in Canada also rose in 1999 by about 2.4% with video expenditures
of about US $2.0 billion. According to Adams Media Research, the total numbers
of videos purchased by consumers in 1999 was 685 million compared to 674 million
in 1998. As well, according to the VSDA 90% of all US adult VCR owners have
rented a video at least once a week.
Sales of VCRs continue to grow. According to the Consumer Electronics
Association, 22 million VCRs were sold in the US up 26% from 1998. As well, US
consumers bought approximately 3.7 million DVD players in 1999 According to
Adams Media Research, DVD sales are expected to increase over 800% from $4.6
milllion in 1999 to $41.87 million in 2004, therefore expanding the opportunity
for entertainment sales.
The Recording Industry Association of America reported North American music
industry revenues of US$13.2 billion in 2001, representing a 3.1% increase over
the previous year. North America represents the greatest music market, followed
closely by Europe. Japan falls into third place with approximately 50% of the
volume of sales achieved in Europe. Worldwide music sales total over US$38
billion annually. In the video games market, also referred to as interactive
entertainment media, retail sales in the United States were US$6.0 billion in
2000 according to the NPD Group, an international marketing information company
based in Port Washington, New York. Electronic or computer-based games fall into
four major categories; personal computer games, console or next generation
games, hand-held games, and online games accessed via the Internet.
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The retail market for video and home entertainment has changed dramatically over
the last five years and has been characterized by a consolidation of many of the
smaller independent operators. Once a cottage industry of small privately owned
enterprises, the market has now largely been rolled up with concentrated
ownership in the hands of a few large publicly traded corporations. This
consolidation has occurred primarily as a result of the fact that most retail
outlets needed increasing amounts of capital to keep pace with the ever growing
number of titles produced by the major studios, as well as the expanding "copy
depth" programs offered by the larger chains that carry both a broad selection
and extensive number of per title copies in an effort to ensure that the
consumer is not disappointed by their respective selection not being available
for rental. As many independent retailers were unable to compete, the major
operators acquired many retailers and many retailers simply closed their
businesses.
Over the last decade the home entertainment industry at the retail storefront
level has experienced tremendous growth in the dollars spent by consumers on
video rental. We believe that this is due partly to the fact that VHS player
penetration into households still ranks as one of the most successful product
introductions ever, as well as the fact that studios continue to expand both the
number and quality of offerings to the market. Consumers continue to have a
large demand for home video, and at present, the revenues generated from video
release comprise up to 60% of a studio's revenues associated with a title
release. The studios thus make concerted efforts to protect the revenues
resulting from this market, and, as such, continue to introduce marketing
techniques to expand this sector, including direct to video releases, as well as
"sell-through" pricing on well performing "A" titles whereby such titles are
introduced at pricing for retail sale (as opposed to rental). This sell-through
pricing allows retailers to benefit from lower acquisition costs for rental
inventory, as well as the opportunity to sell such titles.
We view the recent market success of digital versatile discs ("DVDs") to be a
major factor for the home entertainment market. The DVD format incorporates
several advanced features, including digital quality picture and sound,
outtakes, additional footage, multiple language encoding, special director's
cuts and pans of scenes, the ability to edit content on the fly to match a
particular rating or make the title suitable for a particular audience and the
ability to "jump" from scene to scene. These features have made DVD the most
successful new home entertainment product offering for the last three years. We
have made substantial investment into DVD inventory for rental and revenues
generated from DVD continue to increase at dramatic rates, particularly in the
urban centers.
We also view new hardware product offerings such as Sony's Playstation 2(TM),
Microsoft's X-BoxTM and the Nintendo Game CubeTM to be a significant factor in
the video and home entertainment industry. The Playstation 2(TM) features the
ability to play DVD movies, DVD or CD-based video games and CD-based music all
on a single platform. This convergence of technologies will likely result in a
convergence of media platforms toward DVD and may result in even greater
penetration of DVD-compliant hardware than exists today.
Over the last five years the retail market has transitioned away from a model
whereby the video retailer buys a copy of a title and rents the copy for a
return of its capital to a model whereby the major studios provide the title at
a low initial capital cost, and the revenues are then shared between the studio
and the retailer. This model has been used by theatres for decades and now is
becoming increasingly prevalent in the home entertainment market as well. The
revenue sharing model is available to most retailers through third parties such
as Rentrak Corporation, or directly with the studios themselves. The difference
between direct and third party models is principally (i) the up front capital
cost (ii) the percentage of revenues retained by the retailer, and (iii) the
cost of "buying" out the title at the end of the
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contract. Typically, third party contracts result in greater upfront costs,
lower revenue sharing percentages to the retailer, and higher buyout costs.
Consequently, those retailers that have been able to obtain direct studio deals
have held a competitive advantage in the marketplace and thus have been able to
provide both a greater selection of titles and a greater number of copies
in-store of each title.
To date, we have participated in revenue sharing through a third party
arrangement with Rentrak Corporation, and, more recently, directly with a number
of studios. We believe that we will retain our contractual and strategic
alliance with Rentrak Corporation in the future for the supply of product from
studios that we do not enter into revenue sharing arrangements with, and for
studios that do not offer direct revenue sharing programs. We cannot assure you
that we will successfully negotiate revenue sharing arrangements with other
movie studios or that we will maintain our revenue sharing arrangement with
Rentrak. Our inability to maintain revenue sharing arrangements would have a
materially adverse effect on our business and results of operations.
OUR RETAIL BUSINESS GROWTH STRATEGY
Our business strategy is to compete in neighborhood markets in large urban
centers, small urban centers and rural markets with a trading area population
averaging approximately 10,000. We believe that the advantages of targeting
these markets are:
o less competition;
o the ability to develop market share at lower per customer expense;
o lower fixed costs (leased space);
o lower staffing costs; and
o lower existing market penetration by competitors.
We generally charge rental rates that are competitive with rates charged by our
competitors.
We intend to grow by establishing new, or acquiring established, video and home
entertainment stores.
We intend to apply specific selection criteria when evaluating new locations,
including:
o trading area population base within 20 miles exceeding 5,000 to
10,000 persons;
o competition in area;
o availability of convenient retail space with available parking;
o traffic, frontage and exposure at retail site; and
o demographic characteristics of the area (household size, age and
income).
OUR RETAIL STORES
Our video and home entertainment stores are typically located in retail strip
shopping centres and well-located stand-alone retail stores and range in size
from 3,500 to 6,000 square feet. Our stores are open seven days a week,
generally from 10 a.m. to 12 midnight.
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Our stores display new release movies alphabetically and catalogue titles are
displayed alphabetically by category, such as "Action," "Comedy," "Drama" and
"Children." Our typical store's inventory consists of video cassettes ("VHS"),
digital versatile discs ("DVD"s), video games and music compact discs ("CD"s).
The actual inventory of each store varies depending on its location. We
continually review each store to ensure that inventory for both rental and sale
is meeting local demand. Also, each store has a few special interest titles,
covering such subjects as hunting, golf and education, selected by management to
appeal to the customer base in the store's local market area. We make buying
decisions centrally and base these decisions on box office results, actual
rental history of comparable titles within each store and industry research.
Based on our experience, we believe that our typical store's revenues are
affected by internal factors such as our new release title selection and the
number of copies of each new release available for rental as compared to our
competitors. We are committed to offering as many copies of new releases as
necessary to be competitive within a market, while at the same time keeping our
costs as low as possible. New VHS tapes, DVDs and music CDs offered by us for
sale are primarily "hit" titles promoted by the studios for sell-through, as
well as special interest titles, children's titles and seasonal titles related
to particular holidays.
We design each store using uniform store fixtures, equipment and layout to
create brand identity. Our stores play movie previews and promotions of coming
attractions on in-store video and sound preview systems for the enjoyment of our
customers. Each of our stores is decorated in bright and attractive colours and
features posters and stand-up displays promoting specific movie, music and video
game titles. We arrange movies and video games in attractive display boxes
organized into categories by topic, except for new movie and video game rental
releases, which are assembled alphabetically in their own section for ease of
selection by customers.
Our stores were originally operated under the brand "Video Headquarters". During
the past 18 months, we have adopted a new format under the "VHQ" brand. This new
format is designed to generate higher traffic volumes and repeat business as
part of our branding effort. Our store layout uses inviting colours,
state-of-the-art entertainment systems, and a broad selection of
entertainment-related products, including music CDs, video game accessories,
video games for sale, studio merchandise related to filmed entertainment and
music, sell-through filmed entertainment and an expanded selection of DVD titles
for rent. As part of our branding strategy, we are in the process of painting
and installing new fixtures in existing stores and in making physical layout
changes to enhance check-out processes. The final stage of our branding strategy
will be to update store exteriors and signage. We believe that the increased
product selection provides opportunities for cross-product promotion in order to
increase the average size of a purchase. We have opened 13 locations using the
new format and have begun the introduction of the new format in an additional 17
locations. As of the date of this annual report, the remaining stores continue
to operate under the "Video Headquarters" brand.
Generally, we spend approximately $225,000-$275,000 to open each new store.
These costs are net of tenant inducements and include tenant finish, fixtures,
computers, point-of-sale equipment, security devices, interior and exterior
signage, inventory for rent, deposits, staff recruitment and training, and
inventory for sale.
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Our policy is to constantly evaluate our existing store base to determine where
improvements may benefit our competitive position in the areas we serve. In
negotiating leases, we attempt to negotiate flexible lease terms to allow us to
react to changing demographics and other market conditions.
In the future, we may actively pursue relocation opportunities to adapt to
market shifts. Similarly, we may elect to expand and/or remodel certain of our
stores in order to improve facilities, meet customer demand and maintain the
visual appeal of each store.
OUR EXISTING RETAIL LOCATIONS
At the time of completion of our acquisition of Integrated Retail Corp. on
September 18, 1998, Integrated operated seven video and home entertainment
retail outlets in Alberta. Since that date, we opened 20 new video and home
entertainment retail outlets in Alberta and one in Yellowknife, Northwest
Territories. On September 29, 1999, we acquired Safiqa, which owned four video
and home entertainment stores in the Calgary market operating under the trade
name "Rainbow Video." On December 1, 1999, we acquired Star Vision, which
operated six video superstores in the Saskatoon market operating under the trade
name "Family Video." On March 21, 2000, we acquired the two "Movies Plus" video
and home entertainment retail outlets located in Calgary. On June 15, 2000 we
acquired the assets of "Silver Screen Video", a video and home entertainment
store in Saskatoon, Saskatchewan. On July 11, 2000, we acquired two video stores
located in Spruce Grove and Stony Plain, Alberta. On March 15, 2001, we acquired
the assets and business operations of a video rental and retail store operating
in La Ronge, Saskatchewan. These openings and acquisitions bring the total
number of our home entertainment outlets now operating up to 49. We expect to
open our 50th store in January 2003. It is management's intent to convert all of
our stores to the VHQ Entertainment, Inc. brand over the course of the next
year.
Set forth below are the locations of our video specialty outlets (as at October
31, 2002).
<table>
<caption>
- --------------------------------------------------------------------------------------------------------------------
NAME OF LOCATION CITY/TOWN PROVINCE OR TERRITORY
- --------------------------------------------------------------------------------------------------------------------
<s>
Video Headquarters or VHQ Sylvan Lake; Red Deer - North; Blackfalds; Wetaskiwin; Leduc; Alberta
retail outlets Drayton Valley; Rocky Mountain House; Whitecourt;
Lloydminster; Lacombe; Lethbridge - North; Lethbridge - South;
Ft. Saskatchewan; Airdrie; Edmonton - Northwood; Edmonton -
Millwoods; Red Deer - South; Calgary - Northpointe; Calgary -
West Market; Okotoks; Calgary - Lake Chaparral; Brooks;
Drumheller; Calgary - Abbeydale; Calgary - Castleridge;
Calgary - Riverbend; Calgary - Westgate; Calgary - Monterey;
Calgary - Braeside; Spruce Grove; Stony Plain; Lethbridge -
West; Calgary - Panorama Hills; Calgary - Coral Springs;
Ponoka; Calgary - Dover; Calgary - Kingsland; Camrose; Leduc
- South.
- --------------------------------------------------------------------------------------------------------------------
Video Headquarters retail Yellowknife. Northwest Territories
outlets
- --------------------------------------------------------------------------------------------------------------------
22
<page>
<caption>
- --------------------------------------------------------------------------------------------------------------------
<s>
VHQ retail outlets La Ronge; Saskatoon - 115th St.; Saskatoon - 8th St.; Weyburn; Saskatchewan
Saskatoon - Churchill; Saskatoon - Lawson; Saskatoon -
Confederation; Saskatoon - Lakeview; Saskatoon - Forest Grove.
- --------------------------------------------------------------------------------------------------------------------
</table>
MARKET SEGMENTS AND REVENUE MIX
Our principal revenues are derived from the following categories (a) video and
DVD rental; (b) video game rental; (c) confectionery sales; (d) video, and (e)
music, DVD, and video gaming software sales. The sale and distribution of each
category of product is conducted principally through our retail storefronts
located entirely in western Canada (principally Alberta) and the Northwest
Territories, and via the Internet through our website, www.vhq.ca. For the last
two fiscal years, the breakdown of sales in each category as a percentage of
gross revenues is as follows:
<table>
<caption>
- -----------------------------------------------------------------------------------------------------------------------
CATEGORY FISCAL 1999 FISCAL 2000(1)<F1> FISCAL 2001 FISCAL 2002
- -----------------------------------------------------------------------------------------------------------------------
<s>
Video and DVD rental: 79.3% 74.3% 67.6% 66.5%
- -----------------------------------------------------------------------------------------------------------------------
Video game rental: N/A 5.2% 9.9% 8.9%
- -----------------------------------------------------------------------------------------------------------------------
Confectionary sales: 5.0% 5.1% 6.5% 6.3%
- -----------------------------------------------------------------------------------------------------------------------
Previously viewed video/gaming software 2.0% 1.6% 1.0% 3.0%
sales:
- -----------------------------------------------------------------------------------------------------------------------
Sell-through video/gaming software sales: 13.6% 11.0% 8.9% 8.2%
- -----------------------------------------------------------------------------------------------------------------------
Music sales: 0.1% 2.8% 6.1% 7.1%
- -----------------------------------------------------------------------------------------------------------------------
<FN>
(1)<F1> In 2000, we began diversifying our product mix to include studio and
other entertainment related merchandise, including clothing, posters and
memorabilia.
</FN>
</table>
SEASONALITY OF THE RETAIL VIDEO INDUSTRY
The video and home entertainment industry is characterized by a degree of
seasonality related to weather and such other factors as holidays and school
holidays. Generally speaking, the industry experiences its greatest sales during
periods of inclement weather typically experienced during the winter when
outdoor or other competing activities may not be available. During periods of
weather conducive to outdoor activities, particularly during the summer months,
sales are adversely affected. To a large extent sales are affected by holidays
and school holidays when families and school children are at home. During the
winter months this effect is substantial on sales, in particular during holidays
for Christmas and Easter when the industry experiences its greatest sales.
During the summer months the effect of children not attending school is
material, particularly toward the end of the summer holiday period.
LICENSES / SOURCES AGREEMENTS
We source our product lines through a number of suppliers. Approximately 43% of
our VHS and DVD rental assets are supplied through Video One Canada Ltd. ("Video
One"). Rentrak Corporation
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("Rentrak") provides approximately 7% of our VHS and DVD rental assets. We have
a one year non-exclusive Product Fulfillment Agreement with Video One which,
unless renewed, extends through January 30, 2003. Under the agreement, Video One
supplies us with film entertainment rental and retail products, entertainment
merchandise and video game rental products.
We also have a ten year non-exclusive Revenue Share Agreement with Rentrak
Corporation. This agreement also provides for the supply of rental products on a
revenue share basis.
The other 50% of our VHS and DVD rental and retail product is sourced through a
number of direct revenue sharing agreements we have with a number of the major
studios (see "Video and Entertainment Industry" above), other product purchase
arrangements we have with individual suppliers and wholesalers.
To date, we participated in revenue sharing through a third party arrangement
with Rentrak Corporation, and, more recently with a number of studios directly.
We believe that we will retain our contractual and strategic alliance with
Rentrak Corporation in the future for the supply of product from studios not
dealing directly with the Company and for studios that do not engage in direct
revenue sharing programs.
We obtain our video game product almost entirely from Video One and our music
from Langara Distribution Inc., a music distribution company owned by Wilmington
Rexford (formerly E-Trend Networks, Inc.). See "Wilmington Rexford" (formerly
"E-Trend Networks, Inc."). We continually review arrangements with third-party
suppliers and may, in the normal course of business, change such suppliers if
more advantageous terms of supply can be negotiated.
MARKETING AND ADVERTISING
We have developed a comprehensive advertising and promotion strategy that is
implemented in the various markets depending on the market demographics. The
various marketing approaches include:
1. LOCAL STORE MARKETING/SALES PROMOTIONS
Sales promotions include price discounts, contests, and daily or weekly
features. Also, each retail store is encouraged to participate in local
community events, including sports, charities and other public
functions.
2. BULK MAIL
The mailing of unaddressed fliers with coupons is one of the most
effective ways of building store traffic and maintaining customer
loyalty.
3. RADIO ADVERTISING
Radio advertising is a core strategy used in major markets. It is also
a key element in building the recognition of the VHQ brand.
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4. PRINT
Newspaper advertising is used on a local level to promote in-store
activities and major product announcements.
5. OUTDOOR SIGNAGE
In highly competitive markets, outdoor advertising (including billboard
and transit signage) is used in the perimeter marketing area of the
competition. This is a defensive strategy to keep the VHQ brand front
and center in locations where consumers have a choice as to where they
buy or rent home entertainment software.
6. THIRD PARTY PARTNERSHIP/STRATEGIC PARTNERS
Participation in cross-promotion with strategic partners and co-op
advertising in conjunction with film studios and music labels is done
on an ongoing basis. Also, each store is mandated to continually
exploit cross-marketing opportunities (such as cross-couponing) with
other retailers, such as pizza stores, in its local market.
7. CUSTOMER DATA BASE
Customers who fail to return to a store in a specified period of time
are contacted directly. This contact is managed via telephone and/or
direct mail. More recently we have adopted new marketing strategies,
including "late fee" waivers and $5.00 credit vouchers to bring
customers back.
Our current marketing budget is approximately 1% of sales. We also receive
funding for advertising through various vendor co-operative advertising funds
and market development funds established with product suppliers and movie
studios. We also benefit from advertising marketing done by studios and theatres
in connection with the promotion of the theatre release of films. We expect we
will increase our marketing budget, particularly as we add television
advertising, and as we continue to add new stores to the chain.
Our retail stores are actively involved in their respective communities, and are
focused on meeting the needs of their loyal customers.
INVENTORY
Inventory consists of new and used software of VHS tapes, DVDs and video games,
CD music and confectionary available for sale. As at May 31, 2002, the inventory
value of VHS tapes, DVDs and video games was $650,253, the inventory value of CD
music was $1,011,711 and the inventory value of confectionary available for sale
was $198,277.
STORE RENTAL ASSETS
The VHS tapes, DVD, and video game assets available for rent in each store
consists of our catalogue titles (those in release for more than one year) and
new release titles. New releases of VHS tapes and
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<page>
video games purchased from suppliers for existing stores are drop-shipped to the
stores. Our stores generally offer from 5,000 to 10,000 VHS tapes, from 1,000 to
5,000 DVDs, and from 500 to 1,500 video games, depending upon location. We
generally have a one-day rental term for new release movies less than 21 days
old which tends to keep new releases more readily available. Rental terms for
new releases greater than 21 days old but less than 120 days old are generally
two days and rental terms on children's, catalogue titles and titles greater
than 120 days old are generally seven days. Video games generally have a two-day
rental term for the most recent new releases and seven days for older, catalogue
titles.
VHS tapes, DVD, and video games used as initial capital assets in our new stores
consist of excess copies of catalogue titles and new release titles from
existing stores, supplemented as necessary by purchases directly from suppliers.
Each rental VHS tape, DVD and video game is removed from its original packaging,
and an optical bar code label used in our computerized inventory system and a
security label is applied to the media directly. The cassette is placed in the
rental case, and the original product packaging is then used for display
purposes. The repackaged VHS tapes, DVDs, video games and display cartons are
then shipped to the store ready for use. Additionally, each store has certain
VCRs, televisions and game players that are available for rent. As at May 31,
2002, the total net book value of all VHS tapes, DVDs and video games available
for rent was $6,896,791. As at May 31, 2002, the total net book value of all
VCRs, televisions and game players available for rent was $179,137.
INFORMATION SYSTEMS
Each of our stores is equipped with a point-of-sale ("POS") system. Our POS
system provides detailed information with respect to a store's operations
(including the rental history of titles and daily operations for each store).
Our POS system tracks all rental and sale information using scanned bar code
information. Each night our POS system transmits store data to the management
information system ("MIS") at our corporate office. All data is processed,
generating reports which allow our management to effectively monitor store
operations and inventory, as well as to review rental history by title and
location to assist in making purchasing decisions with respect to new releases.
Our POS system also enables us to perform a monthly physical inventory using bar
code recognition. Management is currently reviewing our current system and
intends to replace it with a customized POS system that provides greater
functionality and ability to data mine for marketing purposes. Management
intends to develop and implement a new POS system during calendar 2003.
COMPETITION AND TECHNOLOGICAL OBSOLESCENCE
We believe the principal competitive factors in the home entertainment industry
are:
o store location, visibility, and layout and design;
o title selection;
o the number of copies of each new release available;
o customer service; and
o pricing.
26
<page>
The home entertainment industry is highly competitive, and we compete with other
video and home entertainment stores, including stores operated by other regional
and national chains such as Blockbuster Video, Rogers Video, Video Update, Movie
Gallery and Superior Video. We also compete with other businesses offering VHS
tapes, DVDs and video games such as supermarkets, pharmacies, convenience
stores, bookstores, mass merchants, mail order operations and other retailers.
In addition, we compete with all forms of entertainment, such as movie theatres,
network and cable television, direct broadcast satellite television,
Internet-related activities, live theatre, sporting events and family
entertainment centres. Some of our competitors have significantly greater
financial and marketing resources and name recognition than us. Emerging new
technologies such as "Near Video On Demand", "Video On Demand" and digital cable
also provide competition as discussed in "Item 3. Key Information - Risk
Factors".
We cannot assure you that we will successfully compete in the markets that we
serve or that we will generate sufficient revenue and positive cash flow to
remain profitable.
TRADEMARKS
We have or are in the process of applying for various Canadian trademarks
including, but not limited to, "VHQ", the VHQ logo, "WHERE ENTERTAINMENT
BEGINS", and "MOVIES MUSIC GAMES ... AND MORE". We expect to receive final
Canadian trademark approval for those marks in due course but there can be no
assurance that we will be successful.
Our brand names are important to us and we believe that their importance will
increase as we continue to expand our operations. We have sought registration,
where possible, to afford some measure of protection for our intellectual and
intangible property.
We cannot assure you that our efforts to protect our intellectual and intangible
property will be successful.
OUR EMPLOYEES
As of May 31, 2002, we had approximately 420 employees, including 5 employees in
Senior Management, 8 employees in Operations/mid-level management, 61 employees
in Operations/store-level management, 7 employees in head office administration
and approximately 339 employees who service customers in our video and home
entertainment stores. A majority of our employees are either permanent part-time
or part-time employees. Of the total number of employees at such date, 330 were
located in Alberta, 81 in Saskatchewan and 9 in the Northwest Territories.
CORPORATE STRUCTURE
We operate our retail video and home entertainment business directly and through
four wholly-owned subsidiaries: Integrated Retail Corp. ("Integrated Retail"),
an Alberta corporation, Safiqa Holdings Ltd. ("Safiqa"), an Alberta corporation,
Star Vision Enterprises Inc. ("Star Vision"), a Saskatchewan corporation, and
705556 Alberta Ltd. ("705556"), an Alberta corporation.
27
<page>
OUR ACQUISITIONS
In implementing our business strategy, we identified and acquired established
video stores in markets that we targeted. We have completed the following
acquisitions:
OUR ACQUISITION OF INTEGRATED
On September 18, 1998, we acquired Integrated Retail Corp., a retailer
operating seven video stores, from security holders of Integrated,
including the following related parties: Trevor Hillman, at the time
our President and Chief Executive Officer, Gregg Johnson, at the time
our Executive Vice President, Tracy Diane Barker, Sherrie Lee Hillman,
Tari Dawn Gervais, and Timothy Gordon Hillman, pursuant to a Share
Purchase Agreement dated July 20, 1998. The transaction was
non-armslength since a majority of the shares of Integrated were owned
by Trevor Hillman (our Chairman and Chief Executive Officer), his
family members, and Gregg Johnson (our President and Chief Operating
Officer).
Under the terms of the Share Purchase Agreement, we purchased all of
the issued and outstanding common shares of Integrated and certain
outstanding options and broker warrants issued by Integrated, free and
clear of all liens, claims, charges, security interest, and
encumbrances. We agreed to acquire these securities for the following
consideration:
(i) issuance of 5,000,000 (post-consolidation) of our
common shares to the shareholders of Integrated,
including the following related party shareholders:
Trevor Hillman (1,400,000), Tracy Diane Barker
(800,000), Sherrie Lee Hillman (200,000), Tari Dawn
Gervais (800,000), and Timothy Gordon Hillman
(800,000);
(ii) issuance of 200,000 (post-consolidation) of our
common shares to Gregg C. Johnson in exchange for the
cancellation of his options to acquire 250,000 shares
of Integrated;
(iii) issuance of warrants exercisable to purchase 500,000
(post-consolidation) of our common shares at $0.75
per share until March 31, 1999, all of which have
been exercised; and
(iv) issuance of warrants exercisable to purchase 210,000
(post-consolidation) of our common shares at $0.50
per share until March 31, 1999, 104,000 of which were
exercised prior to their expiration.
We also agreed to enter into an employment agreement dated May 1, 1998,
with Trevor Hillman under which Trevor Hillman was appointed as our
President and Chief Executive Officer for a term of five years with an
annual salary of $52,000. The terms of the agreement have been
modified. Currently, the annual salary is set at the greater of $60,000
or an amount equal to one-half of 1% of the gross sales actually
achieved by us during each fiscal year, providing that our earnings
before interest, taxes, depreciation and amortization exceeds 11% on an
annualized basis. See "Item 6 - Directors, Senior Management and
Employees".
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<page>
As VHQ Entertainment and Integrated were under common control at the
time of the acquisition, our financial statements have been presented
using the continuity of interest method of accounting under which the
financial position and results of operations for the current and prior
periods are presented as if the new corporate structure had existed
since inception of Integrated.
OUR ACQUISITION OF RAINBOW VIDEO
On September 29, 1999, we acquired Safiqa Holdings Ltd., of Calgary,
Alberta, an independent video retailer operating four video superstores
in the Calgary market under the brand name "Rainbow Video," pursuant to
a share purchase agreement dated June 1, 1999, by and between VHQ
Entertainment and Ayaz Kara, our Vice President - Business Development,
Nayaz Kara, and Moez Hirji (the "Safiqa Agreement").
Under the terms of the Safiqa Agreement, we acquired all of the issued
and outstanding common shares of Safiqa, free and clear of all liens,
claims, charges, security interest, and encumbrances. We agreed to
acquire these shares for the following consideration:
(i) issuance of a total of 900,000 of our common shares
at a deemed value of $1.25 to Ayaz Kara (450,000),
Nayaz Kara (225,000) and Moez Hirji (225,000);
(ii) $100,000 in cash payable to Ayaz Kara ($50,000),
Nayaz Kara ($25,000), and Moez Hirji ($25,000);
(iii) Promissory Notes in the aggregate principal amount of
$900,000, issued to Ayaz Kara ($450,000), Nayaz Kara
($225,000) and Moez Hirji ($225,000), each payable on
or before March 31, 2000, with interest calculated at
the rate of 12% to December 31, 1999 and 18% from
January 1, 2000 to March 31, 2000, all of which have
been fully paid and cancelled; and
(iv) payment to Ayaz Kara (50%), Nayaz Kara (25%) and Moez
Hirji (25%) of an adjustment to the purchase price
based on the working capital position of Safiqa on
May 31, 1999, to the extent current assets exceeded
current liabilities on such date.
We also agreed to enter into an employment agreement dated June 1,
1999, with Ayaz Kara under which Ayaz Kara was appointed as a Vice
President of the company for a term of three years, with an annual
salary of $50,000 plus 1% of the our gross sales revenues in the
Calgary market. Mr. Kara is currently our Vice President, Business
Development. We also agreed to enter into an employment agreement dated
June 1, 1999, with Moez Hirji under which Moez Hirji was appointed as a
Regional Manager for a term of three years, with an annual salary of
$50,000. Mr. Hirji resigned from his position effective September 15,
2000.
Our acquisition of Safiqa was accounted for by the purchase method of
accounting. Safiqa reported revenues in excess of $2.81 million during
its fiscal year ended December 31, 1998.
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<page>
OUR ACQUISITION OF FAMILY VIDEO
On December 1, 1999, we acquired Star Vision Enterprises Inc. of
Saskatoon, Saskatchewan, an independent video retailer operating six
video superstores in the Saskatoon market under the brand name "Family
Video," pursuant to a share purchase agreement dated December 1, 1999,
by and between VHQ Entertainment and Marc Gignac, our Vice President,
Saskatchewan Operation, and Gisele Gignac (the "Family Video
Agreement").
Pursuant to the Family Video Agreement, we agreed to acquire all of the
issued and outstanding common shares of Star Vision, free and clear of
all liens, claims, charges, security interest, and encumbrances. We
agreed to acquire these shares for the following consideration:
(i) a Promissory Note issued to Marc and Gisele Gignac
in the principal amount of $1,000,000, $500,000
payable on January 31, 2000, and $500,000 payable on
February 29, 2000, with interest calculated at the
rate of 10% per annum, which note was fully paid and
cancelled;
(ii) 1,010,000 of our common shares at a deemed value of
$1.40 issued to Marc Gignac (510,000) and Gisele
Gignac (500,000);
(iii) $500,000 to Marc Gignac and Gisele Gignac pursuant to
a non-competition agreement; and
(iv) a cash payment adjustment to the purchase price based
on the working capital position of Star Vision on
November 30, 1999, to the extent current assets
exceeded current liabilities on such date.
We also agreed to enter into an employment agreement with Marc Gignac for a term
of three years, with an annual salary of $50,000 plus 1% of our gross sales
revenues in the Saskatchewan market. In addition, VHQ Entertainment Inc. issued
an option to Marc Gignac exercisable to acquire 25,000 shares of E-Trend
Networks, Inc. common stock for $1.00 per share until November 31, 2002. This
option was subsequently cancelled on the disposition of our interest in E-Trend.
See "Wilmington Rexford (formerly "E-Trend Networks, Inc."). Mr. Gignac is
currently our Vice President - Saskatchewan Operations and a Director. Our
acquisition of Star Vision was accounted for by the purchase method of
accounting.
OUR ACQUISITION OF MOVIES PLUS
Effective March 21, 2000, we acquired 705556 Alberta Ltd. of Calgary,
Alberta, an independent video retailer operating two video and home
entertainment superstores under the trade name "Movies Plus", pursuant
to a Share Purchase Agreement dated March 21, 2000 by and between VHQ
Entertainment, Inc. and Altaf Hirji and Shelina Hirji (the "Movies Plus
Agreement").
Under the terms of the Movies Plus Agreement, we agreed to acquire all
of the issued and outstanding common shares of 705556 Alberta, free and
clear of all liens, claims, charges, security interest, and
encumbrances. We agreed to acquire these shares for the following
consideration:
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(i) $150,000 in cash to Altaf Hirji ($90,000) and Shelina
Hirji ($60,000);
(ii) Promissory Notes in the amount of $50,000 to Altaf
Hirji ($30,000) and Shelina Hirji ($20,000) payable
on or before April 30, 2000, which Notes have been
fully paid and cancelled;
(iii) Promissory Notes in the aggregate principal amount
of $50,000 issued to Altaf Hirji ($30,000) and
Shelina Hirji ($20,000) payable on or before May 30,
2000, which Notes have been fully paid and cancelled;
and
(iv) 86,207 of our common shares at a deemed value of
$4.35 to Altaf Hirji (51,724 shares) and Shelina
Hirji (34,483 shares).
OUR ACQUISITION OF SILVERSCREEN VIDEO
On June 15, 2000, our wholly-owned subsidiary, Star Vision Enterprises
acquired all the assets of Silverscreen Video, a video and home
entertainment store operating in Saskatoon, Saskatchewan from Raeco
Holdings Incorporated ("Raeco") for the following consideration:
(i) issuance of 25,000 common shares of VHQ Entertainment
to Raeco with a deemed price of $4.00 per share;
(ii) $25,000 in cash paid at closing;
(iii) a payment of $25,000 made on July 15, 2000; and
(iv) a payment of $50,000 made on September 1, 2000.
OUR ACQUISITION OF M&K VIDEO SPOT
On July 11, 2000, we acquired the assets of M&K Video Spot Inc., an
independent video retailer operating a video store in Stony Plain,
Alberta and a store in Spruce Grove, Alberta under the brand name
"Video Spot", pursuant to an Asset Purchase Agreement dated July 11,
2000, by and between VHQ Entertainment and M&K Video Spot Inc.
Under the terms of the Asset Purchase Agreement, we acquired all of the
assets of M&K Video Spot Inc., free and clear of all liens, claims,
charges, security interest, and encumbrances. We agreed to acquire
these assets for the following consideration:
(i) a total of 43,750 of our common shares at a deemed
value of $4 per share to M&K Video Spot Inc.;
(ii) $125,000 in cash payable to M&K Video Spot Inc.; and
(iii) a Promissory Note in the aggregate principal amount
of $125,000, payable in twelve monthly installments
beginning September 1, 2000, with interest at the
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<page>
rate of 9% per year, issued to M&K Video Spot Inc.,
which note has been fully paid and cancelled.
We also granted M&K Video Spot Inc. a security interest in certain of
our assets to secure the payment under the Promissory Note issued to
M&K Video Spot Inc. The principal of M&K Video Spot Inc. entered into a
non-competition agreement in connection with our acquisition of the
assets of M&K Video Spot Inc.
M&K Video Spot Inc. reported revenues of approximately $770,000 during its
fiscal year ended December 31, 1999.
OUR ACQUISITION OF THE ASSETS OF HOLLYWOOD NORTH VIDEO LIMITED
Effective March 15, 2001 we acquired all the assets and business
operations of Hollywood North Video Limited, an independent video
retailer operating a video rental and retail store in La Ronge,
Saskatchewan, for the aggregate purchase price of $70,000, payable by
way of a $40,000 cash payment on the closing date and the delivery of
two $15,000 post-dated cheques for April 15, 2001 and May 15, 2001,
which were subsequently cashed.
WILMINGTON REXFORD INC. (FORMERLY E-TREND NETWORKS, INC.)
In furthering our desire to mitigate the potential risk from the Internet
evolving as a means of the sale and distribution of competing entertainment
content and products, in April 1999 we participated in the formation of E-Trend
Networks, Inc. ("E-Trend"), a Nevada corporation headquartered in Calgary,
Alberta. Through its web site located at WWW.ENTERTAINME.COM, E-Trend created an
online entertainment portal for the sale of filmed entertainment in both VHS and
DVD format, CD music, video games, as well as access to industry related
information and news. At the time of E-Trend's incorporation, we owned 65.8% of
its outstanding common shares. However, our ownership position was gradually
reduced as E-Trend issued shares from treasury to finance its activities.
In January 2000, E-Trend acquired Langara Distribution Inc., a Canadian based
wholesaler of music, to support its music title fulfillment operations. E-Trend
uses Langara Distribution Inc. to provide music procurement and fulfillment for
its own network web site and provide similar services for other Internet based
businesses.
On February 22, 2001, E-Trend was acquired by Cool Entertainment Inc., a
Delaware corporation formerly quoted for trading on the NASD OTC Bulletin Board
("Cool"). As a result of the acquisition, the shareholders of E-Trend became the
controlling shareholders of Cool, Cool changed its name to E-Trend Networks,
Inc. and the Delaware corporation became the parent of E-Trend. At the date of
E-Trend's acquisition of Cool, we owned 40.1% of the issued shares of E-Trend.
On December 26, 2001, we entered into an agreement to sell our entire holdings
in the Delaware corporation, being 2,000,000 shares of common stock, to The Game
Holdings, Ltd., a British Virgin Islands Corporation, for US$0.40 per share, for
an aggregate purchase price of US$800,000. It was agreed that the purchase price
would be payable over 18 months pursuant to a secured Promissory Note delivered
by The Game Holdings, Ltd. as follows:
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(a) US$10,000 per month from January, 2002 until March, 2002;
(b) US$30,000 per month from April, 2002 until May 31, 2003; and
(c) the remainder of the purchase price will be paid on June 30,
2003.
The Promissory Note bore interest at a rate of 6% per annum. The Promissory Note
was to be secured by way of a second charge registration against a yacht owned
by The Game Holdings, Ltd. which as at June 22, 2001 had an estimated market
value of approximately US$1,600,000 and a replacement value of approximately
US$2,000,000 as determined by an independent appraiser, the appraisal of which
was delivered by the purchaser.
Subsequently, the parties agreed to amend the original agreement and Promissory
Note in that the payment schedule pursuant to the agreement and Promissory Note
would be revised so that we would receive payment of the purchase price as
follows:
(a) US$30,000 per month on the last day of each month from April,
2002 to September, 2003; and
(b) on October 31, 2003 the remaining outstanding balance of the
purchase price plus accrued and unpaid interest due and owing
would then be paid.
Also the security on the Promissory Note is to be amended in that a pledge of
the shares of The Game Holdings, Ltd. are to be delivered as opposed to a direct
charge against the yacht owned by The Game Holdings, Ltd. As of the date of this
annual report, an executed copy of the Amending Agreement and the revised
Promissory Note have not yet been returned by The Game Holdings, Ltd., and no
written agreement is in place with respect to the pledge of shares. As of the
date of this annual report, no payments have been received from The Game
Holdings, Ltd. as required by the terms of the promissory note.
On February 19, 2002, the Delaware corporation changed its name to Wilmington
Rexford, Inc. and the stock trades under the symbol "WREX" on the OTC Bulletin
Board. E-Trend still operates as the wholly-owned subsidiary of Wilmington
Rexford, Inc.
OUR PROPERTIES AND EQUIPMENT
Our head office is located in Red Deer, Alberta where we operate an
administrative and central distribution facility from a 7,000 square foot
facility leased from a related party. Our head office consists of administrative
and executive offices and our central receiving, warehousing and distribution
facility for all our retail locations. We are also the head tenant on a lease
for a 5,000 square foot facility in Calgary, Alberta which is currently being
sublet to and occupied by E-Trend Networks, Inc.
As of the date of this annual report, we operate 49 retail video and home
entertainment stores, all of which are leased from third parties, including 39
stores located in Alberta, with the greatest concentration in central and
southern Alberta, 9 stores in Saskatchewan, and one in Yellowknife, Northwest
Territories. We expect to open our 50th store in January 2003. Five of our
stores are leased from Hillman Holdings Inc., a company beneficially owned and
controlled by Gordon Hillman, the father of Trevor Hillman, our Chairman and
CEO. We lease all of our video and home entertainment
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stores at market competitive rates for each geographic location. The average
term of our video and home entertainment store leases is five years and
typically most leases include one or two renewal options for further five year
periods, priced at a discount to the then prevailing market rates.
ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS
This Management's Discussion and Analysis (MD&A) focuses on key statistics from
the consolidated financial statements of VHQ Entertainment Inc. ("VHQ" or the
"Company") for the twelve month fiscal years ended May 31, 2002, 2001 and 2000,
and pertains to known risks and uncertainties relating to its business. This
MD&A should not be considered all-inclusive, as it excludes changes that may
occur in general economic, political and environmental conditions. The MD&A of
the financial conditions and results of operations should be read in conjunction
with the attached consolidated financial statements for the years ended May 31,
2002, 2001 and 2000, as well as in related notes contained elsewhere in this
annual report.
TWELVE MONTH PERIOD ENDED MAY 31, 2002, COMPARED TO THE TWELVE MONTH PERIOD
ENDED MAY 31, 2001
(ALL FIGURES QUOTED IN CANADIAN DOLLARS UNLESS OTHERWISE INDICATED)
RESULTS OF OPERATIONS
Total revenues for the year ended May 31, 2002 increased 22.4% to 26.1 million
compared to $21.3 million for 2001.
The increase in revenues results from a number of factors, the most significant
of which includes: (i) an 8.9% increase in the number of new stores to 49 as at
May 31, 2002 compared to 45 stores at May 31, 2001; and, (ii) a 6% increase in
same-store sales for the year ended May 31, 2002 compared to the similar twelve
month period in 2001.
The increase in the same-store sales results from: (i) the continued consumer
acceptance and growth of the DVD format resulting in a significant increase in
DVD related sell through and rental revenues; (ii) strong and broad product
availability for customers from direct copy depth programs with movie studios
for filmed entertainment product; (iii) the increase in sales of previously
viewed movies and games; (iv) the continued focus and successful execution of
VHQ's branded sales and marketing campaigns that generate high consumer
excitement, brand awareness and traffic at its stores; and, (v) the continued
growth of music sales and confectionery items.
Same-store sales includes all the stores that were operating during the entirety
of both periods being compared.
The relative mix of revenues between rental and product sales for the year was
78.4% and 21.6% respectively, and was stable compared to 77.7% and 22.3% for the
previous year. During the year, the Company successfully focused on expanding
its selection of DVDs and games for rental and sell through and increasing the
frequency of previously viewed movies sales campaigns to accelerate the turnover
of its rental assets.
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Rental revenues include rentals of VHS tapes, DVDs, video games and sales of
previously viewed movie titles on VHS and DVD formats. The strategic importance
of DVDs as a product offering continues to grow evidenced by DVD rental revenues
exceeding 21.9% of rental revenues compared to 15% of rental revenues for 2001.
Product sales includes the sale of confectionery, CD and cassette based music,
sell-through filmed entertainment on VHS and DVD, gaming accessories, studio
merchandise, posters and ancillary goods.
The Company's success in augmenting and diversifying its rental revenues via
product sales is evidenced by the 26.6% growth of revenues from product sales of
new software, music and confectionery.
COST OF SALES
COST OF SALES FOR RENTALS
The cost of sales for rentals increased 69.8% to $7.42 million for the year
ended May 31, 2002, compared to $4.37 million for the similar period in 2001.
The increase in rental costs mainly results from the 104.3% increase in the
amortization expense attributed to the June 1, 2001 implementation of a 12 month
amortization period for the Company's rental assets compared to a 24 month
amortization period in previous years.
The cost of sales for rentals is comprised of two key components. The first key
component is revenue sharing expenses incurred by the Company with certain movie
studios. The second key component is the amortization of rental assets including
VHS tapes, DVDs, video games and equipment for rent.
For the year ended May 31, 2002, amortization expense on rental inventory
increased to $5.31 million and was 71.5% of the cost of rentals up from $2.60
million or 59.5% for the previous year ended May 31, 2001.
Compared to total revenues, the amortization of rental product expense was 27%
for the year ended May 31, 2002 compared to 15.7% for the similar period in
2001.
The significant increase in the amortization of rental product expense results
from the change in the amortization policy of the Company's rental assets
effective June 1, 2001 whereby the amortization rate of the rental assets was
accelerated to 12 months from 24 months. As a result of this change, the Company
expensed a higher than normal amount of amortization of rental product over the
fiscal year ending May 31, 2002, after which the amortization of rental product
expense is expected to decline to more normalized levels commencing in the first
quarter ending August 2002.
COST OF PRODUCT SALES
The cost of product sales includes the cost of new VHS tapes and DVDs for
sell-through, confectionery items, music, video games and equipment and other
goods inventoried for sale. The cost of product sales as a percentage of product
sales for the year ended May 31, 2002 increased to 83.8% compared to 77.2% for
the previous year due to lower margins earned on confectionery items. The lower
confectionery margins resulted from the numerous movie and confectionery
"Combos" which served to increase traffic and full priced movie rental sales
transactions. To further support confectionery margins, the Company
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expects to reduce the number of confectionery product lines offered and seek
larger volume purchases on a smaller number of items.
GROSS MARGIN
Gross margin as a percentage of total revenues unfavorably declined to 53.5% for
the year ended May 31, 2002 compared to 62.3% for the year ended May 31, 2001.
The decline in gross margin results from the higher amount of amortization of
rental product expense incurred during the year caused by the change of the
amortization policy of rental assets to 12 months from 24 months. This
negatively impacted gross margins by increasing the amortization expense charged
during the year.
STORE OPERATING EXPENSES
Store operating expenses include all store level expenses such as store rent,
telephone, utilities, signage, equipment rental, store personnel labour wages
and benefits, alarm monitoring, taxes and licenses, insurance, and repairs and
maintenance expenses.
During the fiscal year ended May 31, 2002, store operating expenses declined to
39.9% of total revenues compared to 42.7% of total revenues for the year ended
May 31, 2001. The key factor to the decline in store operating costs as a
percentage of total revenues was the careful management of store labor costs
which declined to 18.8% of total sales for the year ended May 31, 2002 compared
to 20.2% for the year ended May 31, 2001. Management believes that customer
service levels, however, remain very high and uncompromised.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses include administrative and warehouse wages
and benefits, advertising and promotion, bank charges, business taxes and
licenses, consulting and professional fees, equipment rental, head office
expenses and rent, travel and entertainment, public company fees, head office
telephone and utilities, shop supplies and insurance for the head office
premises.
General and administrative expenses as a percent of total revenues increased to
12.5% for the year ended May 31, 2002 compared to 10.9% of total revenues for
the similar 12 month period in 2001.
The increase in general and administrative expenses results from increased
accounting, legal and consulting fees related to the Company's various financing
initiatives including the United States Securities and Exchange Commission
registration statement of Form 20F to make the Company's securities tradable in
the United States, as well as the costs associated with the preparation of a
prospectus for a fully marketed distribution of the Company's shares in Canada.
AMORTIZATION OF INTANGIBLES
Amortization of intangibles expense for the year ended May 31, 2002 declined to
$31,776 compared to $361,934 for the similar period in 2001. Effective June 1,
2001 the amortization of intangibles was significantly reduced due to the
adoption of the new accounting treatment as detailed in the CICA handbook
section 3062.
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OPERATING INCOME
The operating loss for the year ended May 31, 2002 was $24,671 compared to an
operating income of $1,241,411 for the year ended May 31, 2001.
INTEREST EXPENSE
Interest expense for the 12 months ended May 31, 2002 increased to $219,765 from
$119,649 for the similar period in 2001. Included in interest expense is
interest of $44,000 related to the 8% convertible debenture which the Company
issued on December 1, 2001.
VIDEO LIMITED PARTNERSHIP DISBURSEMENTS
In December 1999, the Company sold certain capital assets comprised of filmed
entertainment and video games of its wholly owned subsidiary Integrated Retail
Corp. to Video Limited Partnership for net proceeds of $4.0 million, resulting
in a gain of $1.3 million. See "Item 7. Majority Shareholders and Related Party
Transactions - Related Party Transactions." Video Limited Partnership, in turn,
engaged the Company to manage the distribution and rental of such rental assets,
with the parties involved sharing the revenues generated from these capital
assets. The Company had the option to repurchase these capital assets any time
after June 30, 2001.
Pursuant to an agreement effective December 1, 2001, the Company purchased all
of the partnership units from the Video Limited Partners for a total
consideration of $2.1 million payable by way of the issuance of 546,336 units,
with each unit comprised of one common share of the Company and one half of one
common share purchase warrant (for a total of 273,168 warrants being issued),
and the issuance of a $1.28 million three year composite convertible debenture.
The annual rate of interest on the debenture is 8% per annum with blended
monthly principal and interest payments of $40,125 payable over a three-year
term. The principal amount of the debenture can be converted at any time into
common stock of the Company at the option of the holder at $2.50 per common
share to December 1, 2003 and at $3.00 per common share to December 1, 2004.
Each whole warrant issued as part of the units is exercisable into one common
share until December 1, 2003 at $2.00 per share.
As a result of this purchase, the Company effectively eliminated all
disbursements to the Video Limited Partnership effective December 1, 2001. Video
Limited Partnership disbursements declined to $698,299 from $1,509,565 for the
previous year ended May 31, 2001.
WRITE DOWN OF CAPITAL ASSETS
The write-down of certain capital assets relates to the Company's acquisition of
the partnership units of the Video Limited Partnership. In this transaction, the
Company effectively purchased all the VHS tapes previously owned by the Video
Limited Partnership, the units of which were purchased for $2.1 million. The
amount in excess of the residual value of the VHS tapes resulting from the
purchase was subsequently expensed against earnings. The capital asset
write-down of $1.32 million is a non-cash expense.
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NET INCOME
The Company recorded a net loss of $2.3 million for the year ended May 31, 2002
compared to a net loss of $2.8 million for the similar twelve month period ended
May 31, 2001. A significant portion of this loss results from the write-down of
capital assets associated with the purchase of the Video Limited Partnership and
the higher amortization of rental product expense. Management expects net income
to significantly improve with the elimination of Video Limited Partnership
disbursements, with increased focus on control of costs, and with the continuing
maturation of existing stores towards higher, more stabilized and predictable
revenue levels .
LIQUIDITY AND CAPITAL RESOURCES
The Company generates cash from the rental and sale of entertainment software
including VHS tapes, DVDs, CD music and video games. The Company's business is a
cash business and thus the Company does not typically carry receivables from
customers. The Company's primary capital requirements are for opening and
acquiring new stores and for the purchase of rental and sell-through inventory.
Other capital requirements include the refurbishment, remodeling and relocation
of existing stores. The Company has funded its capital requirements primarily
from cash flow from operations, the proceeds of various private placement equity
offerings, senior debt credit facilities, vendor financing and the
securitization of certain assets.
The Company's EBITDA favorably increased 24% to $5.6 million for the year ended
May 31, 2002 from $4.5 million for the previous year ended May 31, 2001. This
increase results from the Company's continued ability to expand revenues via
increases to same-store sales and growing the number of store locations.
EBITDA is a non-GAAP earnings measure and does not conform to Canadian or US
GAAP and may not be comparable to measures presented by other companies. EBITDA
is defined as earnings before interest, current and future taxes, amortization
of capital assets, intangibles and lease inducements, Video Limited Partnership
disbursements, write-down of investments and write-down of capital assets.
EBITDA should be considered in addition to, but not as a substitute for, or
superior to, operating income, net income, cash flow and other measures of
financial performance prepared in accordance with Canadian Generally Accepted
Accounting Principals.
As at May 31, 2002 approximately 85% of our revolving bank credit facilities
were utilized. The Company's revolving credit facilities are not subject to
financial covenants or margining formulas, and are at floating rates. The
Company does not intend to fix any amount of this revolving debt. All borrowings
are in Canadian dollars and the Company does not expect to draw any borrowings
in U.S. dollars.
Other than the ongoing need to purchase rental assets based on the customer
demand and at the Company's discretion, the Company has not entered into any
material contracts obligating the Company to material commitments for capital
expenditures.
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CASH FROM OPERATING ACTIVITIES
Funds provided by operations for the year ended May 31, 2002 increased 42% to
$5.1 million compared to $3.6 million for the year ended May 31, 2001. The major
factors contributing to the increase were the higher reported revenues and the
increased amortization of capital assets and intangibles.
CASH FROM FINANCING ACTIVITIES
Cash from financing activities decreased to $1.5 million for the year ended May
31, 2002, compared to cash of $2.7 million for the year ended May 31, 2001. The
major financing activities included the issuance of long term debt and two
private placements that included the issuance of common stock and warrants to
purchase common stock. During the year, the Company issued $1.28 million, three
year, 8%, convertible debentures and $820 thousand of units consisting of one
common share and one-half common share warrant as consideration for the $2.1
million purchase of the Video Limited Partnership. However, because no cash was
exchanged, neither the issuance of the debentures and units nor the acquisition
of the Video Limited Partnership is a financing or investing activity.
CASH FROM INVESTING ACTIVITIES
Cash used for investing activities was $6.6 million for the year ended May 31,
2002 compared to $6.3 million for the previous year. The key investing activity
was the continual purchase of VHS tapes, DVDs and video games to ensure the
Company's product selection remains new and exciting to customers.
WORKING CAPITAL DEFICIT
At May 31, 2002, the Company had negative working capital of $4.8 million
compared to negative working capital of $2.8 million for the previous year. The
negative working capital results from the accounting treatment of our rental
assets. Rental assets are treated as a non-current asset under Generally
Accepted Accounting Principals because it is a depreciable asset and is not an
asset that is reasonably expected to be completely realized in cash or sold in
the normal business cycle. Although the rental of these assets generate a major
portion of the Company's revenue, the classification of this asset as
non-current results in its exclusion from working capital. The aggregate amount
payable for these assets, however, is reported as a current liability until paid
and, accordingly, is included in working capital. As a result, management does
not believe that working capital is an appropriate measure of our liquidity and
anticipates that its business will continue to operate with a working capital
deficit.
We believe that internally generated cash flow from operations, borrowing
capacity with our credit facilities, cash on hand and trade credit will provide
the necessary capital to fund the Company's operation's of 50 stores over the
foreseeable future. However, to fund a significant increase in the number of
operating stores and/or acquisitions, additional sources of debt and equity will
be required.
On September 30 , 2002 the Company withdrew its prospectus offering of units to
the public owing to unfavorable market conditions at the time. Management
intends to consider the possibility of proceeding with private placements of
shares to fund the future growth requirements of the Company resulting from
acquisitions or a significant increase in the number of operating stores. To
this end, shareholders of the Company approved a resolution authorizing the
Company to proceed with one or more series of private placements that could
result in the issuance of up to 100% of the issued and outstanding
capitalization of
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the Company over the ensuing year. Although management has been authorized to
proceed with a private offering of shares there can be no assurance that such
private placement will proceed, or proceed on terms favorable to shareholders.
OUTLOOK
There is no doubt that the economic downturn since late 2000 has had an impact
on all retailers in Canada. Management believes offering low-cost family home
entertainment, however, positions the Company to continue to prosper even in
these uncertain economic conditions. Throughout fiscal 2002 it was difficult to
access any meaningful equity financings for growth. Despite this, the Company
has demonstrated its ability to grow organically through cash-flow, though not
to the level of growth management had hoped to achieve. Management expects the
Company will continue to grow organically for the foreseeable future until
access to the capital markets for significant growth is possible.
There are many aspects of the home entertainment industry that continue to buoy
management's expectations for the future. DVD has emerged as the fastest adopted
consumer technology in history and this DVD "phenomena" has launched a renewed
interest in the consumer to rent and buy movies. As DVD technology continues to
mature and add new and exciting functionality for the consumer, management
expects Canadian households will continue to demonstrate that the rental of
movies is the primary method for Canadian households to access in-home
entertainment.
In addition to movies, an exciting growth opportunity for the Company is the
evolution of new interactive video gaming platforms that have transformed the
face of gaming. No longer an entertainment choice of pre-teens and teens, new
gamers span an age demographic from pre-teens to retirees. Though hardware costs
have fallen dramatically making gaming affordable for most Canadian families,
the software remains quite expensive and out of the reach of many consumers. To
these disenfranchised consumers in particular, the Company offers a value
proposition of not only "try before you buy", but also the availability of
"previously played" new release games at significant discount to new retail
prices. VHQ management believes that video gaming software rentals and
"previously played sales are likely to deliver significant growth for the
Company over the next three to five years as both new gamers join the fray and
new gaming titles continue to enter and drive the consumer market.
With respect to operations, management has several initiatives underway to
continue to enhance efficiencies, productivity and reduce operating costs across
all levels, from distribution through store operations. The Company continues to
recognize that general and administrative costs remain relatively high as a
percentage of gross revenues and so, in addition to efforts to expand the number
of operating stores, management also intends to seek a reduction of general and
administrative expenses over the course of fiscal 2003. Additionally, management
anticipates an overall reduction of staff turnover through the course of fiscal
2003 as new employee incentives are implemented across the chain. Management is
hopeful that these, and other related operational initiatives, such as profit
sharing and employee ownership programs, will result in a net benefit to
revenues and net profitability over the longer term.
Management believes that overall gross margins are likely to improve slightly
over fiscal 2003 as the Company continues to benefit from growing economies of
scale, as well as the low price point of DVD. Gross revenues are also expected
to improve as the Company continues to add storefronts and experiences same
store sales growth throughout the chain.
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TWELVE MONTH PERIOD ENDED MAY 31, 2001, COMPARED TO TWELVE MONTH PERIOD ENDED
MAY 31, 2000
REVENUES
Total revenues increased 65.5% to $21.3 million for fiscal 2001 from $12.9
million for fiscal 2000. This increase was due to a number of factors, the most
significant of which included (i) an increase in same-store revenues of 47%, and
(ii) a 36% increase in the number of stores operating during fiscal 2001 versus
fiscal 2000 as we added 12 stores to our network during fiscal 2001. The
increase in same-store revenues was primarily the result of:
(i) increased product availability for customers as a result of
direct revenue sharing and copy depth programs for filmed
entertainment products;
(ii) a strong slate of new title releases versus the prior year;
(iii) the continued consumer acceptance and growth of the DVD
platform;
(iv) the successful chain-wide re-branding campaign and internal
marketing program designed to generate more consumer
excitement and purchase of items, including music and
sell-through filmed entertainment;
(v) the addition of CD music sales into a greater number of
stores; and
(vi) increases in ancillary sales, including predominantly
confectionary items.
It has been our experience that new-built stores typically reach mature revenue
streams in 12 to 18 months from opening. Generally speaking, revenue streams
mature earlier in our rural markets and later in urban markets where our stores
face greater competition. As such, for so long as we continue our aggressive
new-build strategy, management anticipates strong revenue and same-store sales
growth results from operations.
The relative mix of revenues between rental and product sales revenues for
fiscal 2001 were 78% and 22%, respectively. This ratio remained consistent with
fiscal 2000 revenues that were 79% and 21%, respectively. Many of the gains
experienced in the addition of sales related to music were offset by similar
gains in rental revenues resulting from greater copy depth and the addition and
growth of the DVD rental market. Our decision to increase our inventory of DVDs
resulted in DVD rental revenues increasing to 15% of rental revenues for fiscal
2001 compared to less than 5% of rental revenues for fiscal 2000.
COST OF SALES FOR RENTALS
Rental revenue costs for fiscal 2001 were 26.4% of rental revenues, a slight
increase from 20.3% in fiscal 2000 due primarily to the significant
concentration of product purchases in the fourth quarter of calendar 2000.
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The amortization expense associated with rental products amounted to $2.6
million, representing 59.5% of the cost of rental revenues for fiscal 2001.
Comparatively, such amortization expenses for fiscal 2000 were $1.5 million,
representing 69.9% of the cost of rental revenues. The decrease in amortization
expense as a percentage of revenue was attributable to our shifting purchases of
new rental product towards revenue sharing programs in which the initial capital
outlay is lower.
We commenced revenue sharing programs in November 2000 and the initial financial
effects of these and subsequent programs were reflected in this period. Our
management anticipates that more significant positive results will be generated
in the future as we derive greater revenue from the rental of product provided
under such revenue sharing agreements.
COST OF PRODUCT SALES
The cost of product sales as a percentage of the revenue generated was 77.2% for
fiscal 2001, a slight decrease from the prior fiscal year results that posted
81.6%. The decrease was primarily attributable to greater supplier discounts,
particularly with respect to purchases of CD based music in the third and fourth
quarters of fiscal 2001.
GROSS MARGINS
Our total gross margin for fiscal 2001 amounted to $13.3 million, an increase of
54.2% over the $8.6 million posted for fiscal 2000. The increase in the gross
margin resulted directly from a significant increase in revenues during the
period, together with a successful program to control expansion costs. Overall
gross margins declined to 62.3% for fiscal 2001 from 66.9% for fiscal 2000, the
decline resulting from our participation in revenue sharing and copy depth
programs for filmed entertainment that, on average, have lower gross margins
than do traditional buying arrangements. Additionally, increasing product sales,
and in particular, CD music sales have negatively affected overall margins for
the period as product sales typically generate lower margins than do rental
sales.
STORE OPERATING EXPENSES
Store operating expenses increased slightly to 43.9% of total revenue for fiscal
2001, up from 42.9% for fiscal 2000. The increase in store operating expenses
was primarily due to an increase in the number of stores operating in urban
centers that generally require higher lease payments per square foot, higher
store updating/rebranding costs and higher wages paid to store level staff.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased to $2.3 million for fiscal 2001
from $2 million in the prior fiscal year. The increase resulted from higher
administration salaries required in connection with the 36% growth in the number
of stores, as well as legal and professional fees associated with our listing on
the Toronto Stock Exchange, and audit fees incurred in connection with back
audits of subsidiaries as required by Regulation S-X of the United States
Securities and Exchange Commission.
Although general and administrative expenses increased over those recorded in
the prior year, they declined favorably to 10.9% of revenues for fiscal 2001 as
compared to 15.2% for fiscal 2000. During
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the period, we began to realize the benefits of economies of scale as G&A
expenses were amortized over a greater number of operating stores.
AMORTIZATION OF INTANGIBLES
Amortization of intangibles decreased slightly to 1.7% in fiscal 2001 versus
1.9% in fiscal 2000. This decrease was primarily due to the increase in
same-store revenue in fiscal 2001. We continued to book additional goodwill in
connection with our acquisitions made during the year. Our management believes
such goodwill additions are likely to continue for the foreseeable future as we
continue our store acquisition program.
OPERATING INCOME
As a result of the above factors, excluding the impact of the amortization
policy change on rental inventory and the write down of investment, operating
income increased by 39.2% to $1.24 million in fiscal 2001, up from $891,794 in
fiscal 2000. Increases in operating income resulted from increased same store
sales and revenue gains.
VIDEO LIMITED PARTNERSHIP DISBURSEMENTS
In December of 1999, we entered into an agreement whereby we sold certain
capital assets for net proceeds of $4.0 million resulting in a gain of $1.3
million. The funds were raised through the disposition of rental movies and
games in Integrated Retail Corp., one of our subsidiaries, to Video Limited
Partnership. The partnership in turn engaged us to manage the distribution and
rental of such rental inventory comprised of movies and games, and the parties
agreed to split the revenues generated from these capital assets. We had an
option exercisable on demand at any time after June 30, 2001 to reacquire these
capital assets.
Payments to Video Limited Partnership amounted to $1.5 million in fiscal 2001 as
compared to $732,990 during fiscal 2000. The increase is attributable to the
fact that payments made during fiscal 2000 commenced in December 1999 and,
therefore, were not made for a full one-year period. Payments to Video Limited
Partnership amounted to approximately $125,000 per month. Of such amount, a
graduated portion is applied to pay down the principal portion of the initial
$4.0 million purchase of capital assets.
Effective December 1, 2001 we purchased all of the Video Limited Partnership
Units for the issuance of 546,336 units with each unit comprised of one common
share of VHQ and one-half of a warrant to purchase a common share, with each
whole warrant exercisable into one common share at an exercise price of $2.00
per share for a period of two years, and $1,280,475 of subordinated 8% three
year convertible debentures, which are convertible in common shares for two
years at $2.50 per share for two years and $3.00 in the third year.
NET INTEREST EXPENSE
Net interest expense decreased to 0.6% in fiscal 2001 versus 1.2% in fiscal
2000. This decrease was primarily due to reductions in average debt outstanding
during fiscal 2001.
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INCOME (LOSS) BEFORE INCOME TAXES AND EXTRAORDINARY ITEMS
In fiscal 2001, we posted a loss before income taxes and extraordinary items of
$387,803 compared to an income of $7,307 reported in fiscal 2000. The relative
results are comparable given the fact that we did not remit payments to Video
Limited Partnership for the whole of fiscal 2000.
RECOVERY OF INCOME TAXES
The income tax recovery in the amount of $1,717,00 for the period is largely
attributed to the change in the estimate of the useful life of rental product
and to the write-down of the investment in E-Trend. As a result of these two
changes, the differences between the tax cost and the accounting cost of certain
assets and liabilities on the balance sheet has been reduced, resulting in a
future tax recovery.
INVESTMENT WRITE-DOWN
As at May 31, 2001 we held a 38.37% equity interest in E-Trend. E-Trend is
engaged primarily in the on-line sale and distribution of movies on VHS and DVD,
music on CD and video games on various platforms. E-Trend is also engaged in the
research and development of technologies and strategies to mitigate the
evolution of the Internet as a means of competitive distribution to us. Due to
current market conditions at the time, and in particular to conditions
respecting high-tech and "dot-com" companies in general, our management decided
to take a one-time, non-cash charge and effect a write down in the value of its
ownership in E-Trend. We sold our interest in E-Trend on December 26, 2001 to
The Game Holdings, Ltd. See "Item 4 - "Information on the Company - E-Trend
Networks, Inc.".
WRITE-DOWN OF CAPITAL ASSETS
Effective May 31, 2001, we changed our estimation of the useful life and salvage
value of our rental products. As a result of this change, we have revised our
estimates of the useful life of rental products to a 12 month amortization
period from 24 months and have reduced our estimate of the salvage value per
item. This change has been applied prospectively as a change in accounting
policy and resulted in a one-time write-down of capital assets in the amount of
$2.26 million.
NET LOSS
We recorded a net loss of $2.8 million for fiscal 2001 for the reasons stated
above, as compared to a net profit of $2.1 million for fiscal 2000. Our net loss
per share (basic) was $0.24 for the 12 months ended May 31, 2001 compared to a
net earning of $0.21 per share (basic) for the twelve months ended May 31, 2000.
During fiscal 2001, we generated $1.18 million in EBITDA as compared to $1.13
million in fiscal 2000. The increase in EBITDA was driven primarily by operating
earnings resulting from a 65.5% increase in total revenues.
CASH FROM OPERATING ACTIVITIES
Net cash provided by operating activities was $3.55 million for fiscal 2001 as
compared to $3.24 million for fiscal 2000. The major components of the cash from
operating activities was amortization of capital assets of $3.33 million of
which $2.60 million or 78% was amortization of rental assets, $2.26 million
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from the write down of rental assets, $1.89 million from the write down of the
value of our investment in E-Trend, and $721,186 from the net change in non-cash
components of working capital.
The net change in non-cash components of working capital decreased to $721,180
for the twelve months ended May 31, 2001 from $1.19 million for the twelve
months ended May 31, 2000. During fiscal 2001, we received payment in full on
the $884,009 note receivable from the Video Limited Partnership. Inventory,
which consists of mainly music based software such as CDs and cassettes,
increased to $1.5 million from $789,971 as we stocked a greater number of our
stores with music product for sale.
CASH FROM FINANCING ACTIVITIES
In June 2000, we entered into a short-term credit facility with Community
Savings for a secured, revolving line of credit in the amount of $800,000. This
facility augmented an existing short-term revolving facility offered through the
TD Bank and Trust in the amount of $200,000 for an aggregate short-term
revolving credit line of $1.0 million.
Net cash provided by financing activities was $2.7 million for fiscal 2001 in
comparison to $987,081 in the prior fiscal year. The major contributors to cash
from financing activities for fiscal 2001 were the 366,754 shares that we sold
for approximately $1.38 million as well as an increase of $731,325 in the
utilization of the Company's short-term credit facilities. Proceeds from
long-term debt also increased during 2001, although the net effect of such
proceeds was offset by even greater repayments of long-term debt made during the
fiscal year.
On March 21, 2001 we also entered into a long-term expansion credit facility
with Community Savings in the amount of $1.5 million (the "Facility"). The
Facility was available to us for expansion purposes only and not to fund general
working capital needs. The Facility was secured by a $1.5 million deposit by us
at Community Savings. In order to make draws under the Facility certain
covenants with respect to substantial completion of the store, as well as other
operating and capital criteria had to be met.
CASH FROM INVESTING ACTIVITIES
Net cash used in investing activities was $6.3 million for fiscal 2001 as
compared to $4.2 million for fiscal 2000. This increase in funds used for
investing activities was primarily the result of increases in capital
expenditures of $6.97 million, primarily related to rental inventory and
property, furnishings and equipment purchased to support the growth in our store
base, our increased new store development plan, and a strategic move to stock
greater copy-depth of product. As well, we used $225,000 cash as part of the
consideration towards the purchase Silver Screen video (one store) and M&K Video
(two stores).
WORKING CAPITAL DEFICIT
At May 31, 2001, we had a working capital deficit of $2.89 million, due to the
accounting treatment of our rental inventory. Rental inventory is treated as a
noncurrent asset under generally accepted accounting principles because it is a
depreciable asset and is not an asset that is reasonably expected to be
completely realized in cash or sold in the normal business cycle. Although the
rental of this inventory generates the major portion of our revenue, the
classification of this asset as noncurrent results in its exclusion from working
capital. The aggregate amount payable for this inventory, however, is reported
as a current liability until paid and, accordingly, is included in working
capital. Consequently, we believe
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that working capital is not an appropriate measure of our liquidity and we
anticipate that we will continue to operate with a working capital deficit.
TWELVE MONTH PERIOD ENDED MAY 31, 2000, COMPARED TO THE TWELVE MONTH PERIOD
ENDED MAY 31, 1999.
REVENUES
Total revenues increased 162% to $12.88 million for the twelve month period
ended May 31, 2000 compared to $4.92 million for the similar twelve month period
in 1999. The substantial increase in revenues resulted from a 136% increase in
the number of stores from 14 as at May 31, 1999 compared to 33 as at May 31,
2000, and a 14.9% increase in same-store sales for the twelve months ended May
31, 2000 compared to the similar twelve month period in 1999.
During fiscal 2000 we added 19 stores. Eleven of these stores were added during
the third and fourth quarters of fiscal 2000, including six stores that we
acquired from Star Vision Enterprises Inc. ("Star Vision") in Saskatoon, two
stores in Calgary that we acquired from M&K Video Spot and three new build store
locations. Accordingly, much of the new stores' revenues was not present for the
entire fiscal period and thus the reported revenues were not indicative of
expected annualized revenues.
The relative mix of revenues between rental revenues and product sales for the
twelve months ended May 31, 2000 and the twelve months ended May 31, 1999 was
79% and 21% respectively. Revenues generated from DVDs in fiscal 2000 were less
than 5% of total rental revenues. There were marginal revenues generated from
DVDs in fiscal 1999.
We introduced DVD based entertainment in our stores commencing July 1998 and
introduced CD and cassette based music for sell-through in our stores commencing
July 1999.
COST OF SALES FOR RENTALS
The cost of sales for rentals increased 101% to $2.08 million for the twelve
months ended May 31, 2000 compared to $1.04 million for the twelve months ended
May 31, 1999. The increase in the cost of sales for rentals resulted from our
revenue sharing programs with certain studios which commenced in November 2000
and increased use of copy depth programs.
For the twelve months ended May 31, 2000, amortization expense on rental
inventory was $1.45 million representing 70% of the total cost of rentals,
compared to $643,896 or 62% of the costs of rentals for the twelve months ended
May 31, 1999. Our rental products which include VHS tapes, DVD's, and video
games are amortized, for fiscal 1999 and fiscal 2000. The salvage value for each
unit of rental product is $7.00 per unit.
COST OF PRODUCT SALES
The cost of product sales as a percentage of product sales for the twelve months
ended May 31, 2000 was 82% compared to 68% for the similar twelve month period
in 1999.
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GROSS MARGIN
Gross margin for the twelve months ended May 31, 2000 increased to 66.9% of
total revenues compared to 64.8% of total revenues for the twelve months ended
May 31, 1999.
The increase in the total gross margin resulted primarily from improved gross
margins from rental revenues. Specifically, the overall gross margins from
rental revenues increased from 73% of total rental revenues for the twelve
months ended May 31, 1999 to 80% of total rental revenues for the twelve months
ended May 31, 2000. The stronger gross margins from rental revenues more than
offset the decline in gross margins from product sales, the gross margins of
which declined to 18% of product sales for the twelve months ended May 31, 2000
compared to gross margins of 32% for the similar twelve month period in 1999.
The increase in gross margins from rental revenues resulted from lower revenue
sharing costs as a percentage of total rental revenues for the period as we
purchased fewer movie titles as a percent of total rental revenues under revenue
sharing arrangements in fiscal 2000 than in fiscal 1999.
STORE OPERATING EXPENSES
Store operating expenses decreased as a percent of total revenues to 42.9% for
the twelve months ended May 31, 2000 compared to 46.1% for the twelve months
ended May 31, 1999. Lower year over year rent, amortization of non-rental
assets, equipment rental, and shop supplies as a percentage of total revenues
were the main factors for the improvement in store operating costs as a
percentage of total revenues.
Included in store operating expenses was amortization of assets excluding rental
and intangible assets, which was $370,464 for the twelve months ended May 31,
2000 and $266,200 for twelve months ended May 31, 1999. This increase resulted
from the higher level of capital assets resulting from acquisitions and the
build out of new stores during the twelve month period ended May 31, 2000.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses as a percent of total revenues increased to
15.2% of total revenues for the twelve months ended May 31, 2000 compared to
10.5% of total revenues for the twelve months ended May 31, 1999. This increase,
as a percent of total revenues, primarily resulted from the one time development
expenses of approximately $243,000 related to the development of E-trend, our
e-commerce internet subsidiary.
AMORTIZATION OF INTANGIBLES
Amortization expense of intangible assets increased to $246,288 or 1.9% of total
revenues for the twelve months ended May 31, 2000 compared to $3,819 or .1% of
total revenues for the twelve months ended May 31, 1999. The increase in
amortization of intangibles was the result of our acquisition of Safiqa Holdings
Ltd., Star Vision Enterprises Inc., and 705556 Alberta Ltd., operating as Movies
Plus which were purchased on September 29, 1999, December 1, 1999, and March 21,
2000, respectively.
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NET INTEREST EXPENSE
Interest expense on long term debt increased to $151,497 for the twelve months
ended May 31, 2000 from $8,371 for the twelve months ended May 31, 1999. The
increase in interest costs resulted from additional short term notes and long
term debt borrowed to finance our new store openings and acquisitions. During
fiscal 2000 we repaid, in full, the short term notes payable that were
associated with the acquisition of Safiqa Holdings Ltd. and Star Vision
Enterprises Inc.
OTHER ITEMS
In December 1999, we sold certain rental assets of our subsidiary, Integrated
Retail Corp., to the Video Limited Partnership for net proceeds of $4.0 million
which resulted in a $1.3 million non-cash gain. See "Item 7, Majority
Shareholders and Related Party Transactions - Related Party Transactions".
During the period June 1, 1999 to March 1, 2000 we fully consolidated all the
operations of E-Trend on our consolidated balance sheet, statement of earnings
and statement of cashflow. During this time, we held a majority interest in
E-Trend's voting shares but did not have control of E-Trend's board. Subsequent
to March 1, 2000, as a result of two equity offerings of E-Trend Networks
initiated by E-Trend's board, our interest declined to 38.37% which then
resulted in changing the treatment of our ownership of E-Trend to the equity
method of accounting. This change resulted in a non-cash gain of $2.45 million.
The non-cash minority shareholders interest of $114,572 resulted from the
consolidation treatment of E-Trend to March 1, 2000. The non-cash equity loss on
investment of $268,249 is our proportion of losses that E-Trend incurred from
the period March 1, 2000 to May 31, 2000 based on the equity method of
accounting.
FUTURE INCOME TAX EXPENSE
Future income taxes increased to $1.5 million for the twelve months ended May
31, 2000 compared to $173,000 for the twelve month period ended May 31, 1999.
The increase in future income taxes resulted from an increase in the difference
between the tax cost and the accounting cost of certain assets on the balance
sheet.
NET INCOME
Net income for the twelve months ended May 31, 2000 increased to $2.1 million
compared to $217,383 for the similar twelve month period ended May 31, 1999. Our
earnings per share (basic) was $0.21 in 2000 compared to $0.03 per share (basic)
in fiscal 1999. The increase in net income resulted from the increased number of
stores, gain on disposal of assets to the limited partnership and a gain on
dilution of our equity interest in E-Trend Networks.
CASH FROM OPERATING ACTIVITIES
Funds provided by operations increased to $3.24 million for the twelve months
ended May 31, 2000 compared to $1.30 million for the twelve months ended May 31,
1999. The major contributing factor to the increase was the growth in the number
of operating stores and continued maturation of the revenue
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streams from such stores. The net change in non-cash components of working
capital increased to $1.19 million for the twelve months ended May 31, 2000 from
$9,734 for the twelve months ended May 31, 1999. Accounts receivable increased
to $354,747 for the period ended May 31, 2000 due to increased tenant allowances
receivable from various landlords as we opened six new stores during fiscal
2000. Consistent with the increase in the number of stores, inventory levels
also increased to $789,971 as at May 31, 2000 compared to $214,138 as at May 31,
1999.
CASH FROM FINANCING ACTIVITIES
Financing activities provided cash of $987,081 for the twelve month period ended
May 31, 2000 compared to $1.4 million for the twelve month period ended May 31,
1999. During fiscal 2000, a combination of 575,947 options and warrants were
exercised for net proceeds of $29,348 and 1,996,207 shares were issued for $2.91
million in lieu of cash related to our acquisitions. In addition, the Company
was advanced $361,331 from a related company for operational financing. Fiscal
1999 saw the issuance of 2,624,276 shares for net proceeds of $643,059, the
issuance of a combination of options and warrants for $429,250, and long term
debt, net of repayment of $225,029.
CASH FROM INVESTING ACTIVITIES
For the twelve months ended May 31, 2000, we expended $5.0 million on the
purchase of capital assets, $5.7 million on the acquisition of Safiqa Holdings,
Star Vision Enterprises Inc., and 705556 Alberta Ltd. We paid for these
acquisitions via a cash component of $2.8 million and issued common shares for a
deemed value of $2.9 million.
For the twelve months ended May 31, 1999 we expended $2.7 million that was used
for the build out of seven new stores and to purchase rental product for the new
and existing stores.
A note receivable of $884,009 as at May 31, 2000 was due from the Video Limited
Partnership which bore interest at the rate of 15% per annum, was unsecured, and
was payable upon demand. This note was repaid in cash on Jan 19, 2001.
WORKING CAPITAL DEFICIT
At May 31, 2000, we had negative working capital of $549,127 compared to
$182,719 as at May 31, 1999. The negative working capital resulted from the
accounting treatment of our rental inventory. Rental inventory was treated as a
non-current asset under generally accepted accounting principals because it is a
depreciable asset and is not an asset that is reasonable expected to be
completely realized in cash or sold in the normal business cycle. Although the
rental of this inventory generates a major portion of our revenue, the
classification of this asset as non-current results in its exclusion for working
capital. The aggregate amount payable for this inventory, however, is reported
as a current liability until paid and, accordingly, is included in working
capital. As a result, we do not believe that working capital is an appropriate
measure of our liquidity and we anticipate that our business will continue to
operate with a working capital deficit.
RESEARCH DEVELOPMENT, PATENTS AND LICENSES
Our industry does not require and we have not engaged in any research and
development activities.
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For a list of trademarks we hold or in the process of applying for, please see
"Trademarks" in "Item 4. Information on the Company".
TRENDS
BUSINESS RISKS AND MANAGEMENT
The video rental and home entertainment industry is very competitive. We face a
number of competitors, including larger video retail chains and smaller
independent video rental outlets, music stores and video game stores.
Competition exists mainly on a local basis, with main competitive factors being
price, service and quality. Management continually reviews its competitors and
analyzes upcoming industry trends. There can be no assurance, however, that we
will be successful in addressing competitive threats or adequately assessing
future industry trends.
We have developed a business strategy targeting the secondary retail markets
located in communities of approximately 5,000 - 10,000 people. The strength of
the local economy in these types of communities typically depends upon the
strength of a smaller number of key industries. If the major sustaining industry
in one of these communities is negatively affected, the strength of the entire
local economy will be negatively affected and the amount of disposable income of
the residents in that particular community will decrease. Consequently, a store
operated by us in that location may be negatively affected.
We intend to further increase the number of stores that we operate. The start-up
costs associated with establishing a new store are significant. We have
calculated that it will cost approximately $225,000 to establish each new store
location (and up to $275,000 for each full product mix VHQ Entertainment store).
Such costs may increase as we introduce new concept retail stores in an effort
to match competitor offerings. There is no assurance that we will be able to
obtain adequate financing or adequate cash flows from operations to cover the
projected start-up costs of establishing a new store location.
In order to gain efficiencies generated by economies of scale, we must open a
larger number of stores across a geographically dispersed area. We must rely
initially upon outside sources of capital to finance start-up costs associated
with the opening of new stores as current cash flows alone are not sufficient to
fund new store openings in the numbers anticipated us. In the event we are not
successful in raising additional capital to open new stores, we will not be able
to achieve anticipated efficiencies or pricing structures, all of which could
have a material adverse impact on operations and profitability.
RECENT U.S. ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board ("FASB") approved SFAS
141, "Business Combinations" ("SFAS 141"), and SFAS 142, "Goodwill and Other
Intangible Assets" ("SFAS 142"). SFAS 141 supersedes Accounting Principles Board
Opinion ("APB") No. 16, "Business Combinations." The provisions of SFAS 141: (i)
require that the purchase method of accounting be used for all business
combinations initiated after June 30, 2001, (ii) provide specific criteria for
the initial recognition and measurement of intangible assets apart from goodwill
and (iii) require that unamortized negative goodwill be written off immediately
as an extraordinary gain instead of being deferred and amortized. The Company
adopted SFAS 142 as of January 1, 2002. SFAS 142 is substantially similar to
CICA Handbook Section 3062, Goodwill and Other Intangibles, which the Company
adopted effective June 1, 2001.
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In August 2001, the FASB issued SFAS 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets" ("SFAS 144"), effective for fiscal years
beginning after December 15, 2001. SFAS 144 replaces SFAS 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of." SFAS 144 establishes an accounting model for long-lived assets to be
disposed of by sale, including discontinued operations, and replaces the
provisions of APB Opinion No. 30 for the disposal of segments of a business.
SFAS 144 retains the fundamental provisions of SFAS 121 concerning the
recognition and measurement of long-lived assets to be held and used and the
measurement of long-lived assets to be disposed of by sale. However, SFAS 144
provides additional guidance with regard to discontinued operations and assets
to be disposed of. In addition, SFAS 144 excludes goodwill from its scope. The
impact of the adoption of SFAS 144 is not expected to have a material effect on
the Company's consolidated financial statements.
SFAS 146, "Accounting for Costs Associated with Exit or Disposal Activities"
("SFAS 146") was issued on July 30, 2002 and replaces Emerging Issues Task Force
Issue 94-3, "Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity." SFAS 146 requires companies to recognize
certain costs associated with exit or disposal activities when they are incurred
rather than at the date of a commitment to an exit or disposal plan. SFAS 146
will be effective for exit or disposal activities that are initiated after
December 31, 2002.
ITEM 6. DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES
OUR DIRECTORS, SENIOR MANAGEMENT AND KEY EMPLOYEES
The following table sets forth our Directors and our senior management team,
each an executive officer, and all positions they held with us as of November
30, 2002.
- ---------------------------------------------------------------------------
NAME AND MUNICIPALITY OF CURRENT OFFICE IN THE
RESIDENCE AGE COMPANY
- ---------------------------------------------------------------------------
TREVOR M. HILLMAN, 33 Chief Executive Officer,
Red Deer, Alberta Chairman and Director
- ---------------------------------------------------------------------------
GREGG C. JOHNSON, 38 President, Chief Operating
Red Deer County, Alberta Officer
- ---------------------------------------------------------------------------
43 Senior Vice President,
DERREK R. WONG, Finance and Chief Financial
Olds, Alberta Officer
- ---------------------------------------------------------------------------
MICHAEL D. MCKELVIE 49 Senior Vice President
Calgary, Alberta Marketing & Communications
- ---------------------------------------------------------------------------
AYAZ KARA, 43 Vice President, Business
Calgary, Alberta Development
- ---------------------------------------------------------------------------
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- ---------------------------------------------------------------------------
NAME AND MUNICIPALITY OF CURRENT OFFICE IN THE
RESIDENCE AGE COMPANY
- ---------------------------------------------------------------------------
45 Director of Operations,
MARC L. GIGNAC, Saskatchewan and Director
Saskatoon, Saskatchewan
- ---------------------------------------------------------------------------
TIMOTHY J. SEBASTIAN 37 Director
Edmonton, Alberta
- ---------------------------------------------------------------------------
PETER A. LACEY,(1) 44 Director
Red Deer County, Alberta
- ---------------------------------------------------------------------------
CATHERINE J. MCDONOUGH,(1) 46 Director
Red Deer County, Alberta
- ---------------------------------------------------------------------------
GORDON HILLMAN, 58 Director
Red Deer, Alberta
- ---------------------------------------------------------------------------
Notes: (1) We are required by the CANADA BUSINESS CORPORATIONS ACT to
have an audit committee of the Board of Directors. Messrs. Lacey and
Hillman and Ms. McDonough are currently the members of the audit
committee. We also have a Corporate Governance and Nominating
committee and a Compensation committee, both of which are comprised
of Ms. McDonough and Messrs. Lacey and Johnson.
Our executive officers are appointed by and serve at the pleasure of the board
of directors. Except as disclosed below, to the best of our knowledge, there are
no arrangements or understandings with major shareholders, customers, suppliers,
or others, pursuant to which any of the officers or directors was selected as an
officer or director of the Company.
The information contained herein is based upon information furnished by each
director and executive officer. Except for Gordon Hillman, who is the father of
Trevor Hillman, none of our Directors or executive officers has any family
relationship with any other officer or Director.
The following is a brief biographical information on each of our executive
officers and Directors listed above:
TREVOR M. HILLMAN is our Chief Executive Officer, Chairman of the Board and a
Director.
Mr. Hillman has been our Chief Executive Officer and a Director since
December 11, 1997. He was our President from December 11, 1997 to
November 15, 2001, when he was appointed Chairman of the Board. Also,
since July of 1997, Mr. Hillman has been the President of Integrated
Retail Corp., a start-up venture involved in the retail and rental of
video products (which was acquired by us in September 1998). Mr.
Hillman was a Director of E-Trend Networks, Inc. from inception until
December 26, 2001. Mr. Hillman has been a Director of IROC Systems
Corp., a public company listed on the TSX Venture ("TSX Venture"),
involved in the oil and gas safety industry since March 3, 2000. Mr.
Hillman also has been a Director of Chinook Energy Services Inc., a
public company listed on the TSX Venture, involved in non-destructive
testing in the oil and gas industry, since September 1, 2000. From 1994
to 1997, Mr.
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Hillman provided consulting services to entertainment based retail
clients through TMH Holdings Ltd. Prior thereto, Mr. Hillman was
Operations Manager of Video View Ltd. from August 1983 to 1994.
GREGG C. JOHNSON is our President and Chief Operating Officer.
A graduate of Osgoode Hall Law School of York University in Toronto,
Canada, in 1989, Mr. Johnson was in private practice in Calgary,
Alberta. He then moved to Japan and joined the Japanese law firm Aoki,
Christensen & Nomoto in 1989. In 1991, Mr. Johnson joined the law
office of Dr. Mujahid Al-Sawwaf in Jeddah, Saudi Arabia. In 1993, Mr.
Johnson joined The Tracker Corporation of Toronto, Ontario, a public
company trading on the NASD OTCBB market, where he was primarily
responsible for legal, financing and public reporting matters. Since
August of 1995, Mr. Johnson has provided investment banking services
with Summit Capital Corporation. Mr. Johnson was the Executive Vice
President and Secretary of Merch Performance Inc., a public company
listed and trading on the TSX Venture engaged in the manufacture and
distribution of automotive parts, from April 1997 to June 1998. He
served as our Executive Vice President from December 11, 1997 to
November 15, 2001 when he was appointed as our President and Chief
Operating Officer. He was also a Director from December 11, 1997 to
November 27, 2002. Mr. Johnson also served as a Director of Cervus
Corporation, a public company listed on the TSX Venture engaged in the
acquisition and management of John Deere dealerships from inception
until December 19, 2001, and as a Director of IROC Systems Corp., a
public company listed on the TSX Venture, involved in the oil and gas
safety business from inception until April 9, 2001, and Chinook Energy
Services Inc., a public company listed and trading on the TXS Venture
involved in the non-destructive testing business from September 1, 2001
to January 17, 2002. Mr. Johnson was elected to a second 3-year term in
October 2001 as a councilor with Red Deer County, Alberta and is
currently the Reeve (Mayor of the municipality). Mr. Johnson was the
President of E-Trend Networks, Inc. from inception to February 7, 2001,
and a Director of E-Trend Networks, Inc. from inception to December 26,
2001.
DERREK R. WONG is our Senior Vice President of Finance and Chief Financial
Officer.
Mr. Wong has been our Senior Vice President Finance and Chief Financial
Officer since September 24, 2001. From 1997 to 2001 Mr. Wong was
President of Cirrus Capital Corporation, a financial consulting
company. Through Cirrus Capital Corporation, Mr. Wong provided
financial consulting services, including, but not limited to, services
relating to mergers and acquisitions, investor relations and corporate
finance to Atlas Cold Storage, a wholly owned subsidiary of Atlas Cold
Storage Income Trust, from 1997 to 2000. From 1991 to 1997 Mr. Wong was
Vice President, Corporate Finance of Bank of America. Mr. Wong received
a Bachelor of Commerce degree from the University of Calgary in 1982, a
Masters of Business Administration from the Richard Ivey School of
Business in 1985, and is a Chartered Financial Analyst.
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MICHAEL D. MCKELVIE is our Senior Vice President, Marketing & Communications.
Mr. McKelvie has been our Senior Vice President, Marketing &
Communications since May 1, 2000. Mr. McKelvie has held senior level
marketing, sales and communications positions in the industry since it
started in 1979. After serving as Director, Sales & Marketing for
Universal Studios Home Entertainment Canada for 13 years, he was the
founding partner of EMG Media Inc., where he created and launched
HOLLYWOOD@home(TM), Canada's most-read home video trade magazine. Most
recently, he was Sr. Marketing and Communications Manager for
Blockbuster Canada Co., where he managed the largest TV marketing
campaign ever run by a Canadian video retailer and was solely
responsible for the creation and launch of WWW.BLOCKBUSTER.CA. Mr.
McKelvie served as the Senior Vice President - Marketing for E-Trend
from May 1, 2000 to March 1, 2002.
AYAZ KARA is our Vice-President, Business Development.
Mr. Kara has been our Vice President, Business Development since
September 29, 1999. Mr. Kara also served on the Board of Directors of
the Company from November 22, 1999 to June 5, 2002. Prior thereto, Mr.
Kara was the President and a Director of Safiqa Holdings Ltd. from
February 1993 until September 1999. Mr. Kara is also served as a
Director of IROC Systems Corp., a public company listed and trading on
the TSX Venture, from March 3, 2000 to December 1, 2000. Mr. Kara was
the interim President of E-Trend Networks, Inc. from October 16, 2001
to January 18, 2002 and Mr. Kara has been a Director of E-Trend
Networks, Inc. from December 26, 2001 to present.
MARC L. GIGNAC is our Director of Operations, Saskatchewan.
Mr. Gignac has been our Director of Operations, Saskatchewan since
December 1, 1999. Mr. Gignac also served on our Board of Directors from
March 24, 2000 to November 27, 2002. Prior thereto, Mr. Gignac was the
President and a Director of our Saskatchewan subsidiary, Star Vision
Enterprises Inc. from December 1986 until November 1999.
TIMOTHY J. SEBASTIAN is a Director of the Company.
Mr. Sebastian was our General Counsel and Secretary from October 2000
until April 2002. As of May 1, 2002, Mr. Sebastian resigned as our
General Counsel to return to private practice with the law firm of
Bryan & Company in Edmonton, Alberta. Mr. Sebastian graduated from the
University of Alberta Law School in 1990. He was an associate and then
a partner with the law firm of Bryan & Company in Edmonton and Calgary,
Alberta, from 1990 until October 2000. During his law career, Mr.
Sebastian practiced in the areas of general corporate law, corporate
finance, securities and intellectual property. Mr. Sebastian is also
the Secretary for IROC Systems Corp. and Chinook Energy Services Inc.,
each of which is a public company listed on the TSX Venture. Mr.
Sebastian also served as General Counsel and Corporate Secretary for
E-Trend from October 2001 to January 2002. Mr. Sebastian resigned as
our Secretary and became a director of the Company on November 27,
2002.
54
<page>
PETER A. LACEY is a Director of the Company.
Mr. Lacey has been a Director of the Company since November 22, 1999.
Mr. Lacey has been President, Chief Executive Officer and a Director of
Cervus Corporation, a public company listed and trading on the TSX
Venture, since November 24, 1998. Mr. Lacey has been the President of
Deermart Equipment Sales Ltd., a John Deere farm implement and garden
equipment dealer located in Red Deer, Alberta, since April 1982. Mr.
Lacey has been a Director of Amoil Resources Inc., an oil and gas
company listed and trading on the TSX Venture, since September 1994.
Mr. Lacey has also been a director and the Chairman of the Board of
Q-Tel Wireless Inc., a wireless Internet company, listed on the TSX
Venture since March 2000, operating in Northern Alberta. Mr. Lacey has
been a member of Red Deer College Board of Governors since October
1997.
CATHERINE J. MCDONOUGH is a Director of the Company.
Mrs. McDonough has been a Director of the Company since November 22,
1999. Mrs. McDonough has been and continues to be a successful investor
with over twenty years of investment experience. She owned and operated
a jewellery design business in Honolulu, Hawaii. She has been active in
charitable organizations and has served on the Boards of several of
them including the U.S. Navy Submarine Officer's Wives Club and various
charitable causes related to the Pearl Harbor Naval Station. Mrs.
McDonough currently resides in Red Deer County, Alberta.
GORDON HILLMAN is a Director of the Company.
Mr. Hillman has been President of G&J Holdings Inc. since 1967 and has
started and operated many businesses throughout Alberta under this
company. This includes the building of Video View from one small 1,000
square foot store in Red Deer, Alberta in 1983 to a chain of 23 stores
throughout Alberta, which were sold in January of 1997, as well as the
operation of dollar stores which have also recently been sold. Mr.
Hillman has also been actively involved in real estate development
throughout Alberta through Hillman Holdings Inc., another company of
which he is President. Mr. Hillman is a past Director of Merch
Performance Inc., a public company now trading on Tier 3 of the CDNX.
Mr. Hillman became a director of the Company on November 27, 2002.
None of our Directors and/or executive officers have been the subject of any
order, judgment, or decree of any governmental agency or administrator or of any
court of competent jurisdiction, revoking or suspending for cause any license,
permit or other authority of such person or of any corporation of which he is a
Director and/or executive officer, to engage in the securities business or in
the sale of a particular security or temporarily or permanently restraining or
enjoining any such person or any corporation of which he is an officer or
Director from engaging in or continuing any conduct, practice, or employment in
connection with the purchase or sale of securities, or convicting such person of
any felony or misdemeanor involving a security or any aspect of the securities
business or of theft or of any felony.
55
<page>
COMPENSATION
COMPENSATION OF DIRECTORS
At the present time, we have five Directors. Outside Directors receive $500 per
meeting to a maximum of six meetings per year.
As of November 30, 2002, our Directors (including Directors who are also
officers) held outstanding, exercisable options and warrants to purchase a total
of 739,410 of our common shares. See "Item 6 - Directors, Senior Management, and
Employees - Share Ownership".
RETIREMENT PLANS
We do not offer a retirement plan or retirement benefits to our officers or
directors.
EXECUTIVE OFFICERS
The aggregate compensation paid to all our executive officers in our fiscal year
ended May 31, 2002 was $815,565. The following table details compensation
information for Mr. Trevor M. Hillman, our Chairman and Chief Executive Officer,
Gregg C. Johnson, our President and Chief Operating Officer, Timothy J.
Sebastian, a Director (formerly our General Counsel and Secretary) and Ayaz
Kara, our Vice President Business Development for the periods indicated. We are
not required to disclose and do not publicly disclose the compensation of any
executive officer unless such officer received a combined base salary and bonus
of more than $100,000 during our fiscal year ended May 31, 2002.
<table>
<caption>
- ----------------------------------------------------------------------------------------------------------------------------
Long Term
Compensation
- ----------------------------------------------------------------------------------------------------------------------------
Annual Compensation Awards
- ----------------------------------------------------------------------------------------------------------------------------
Name and Principal Fiscal Other Annual Securities Under All Other
Position Year Salary Bonus Compensation Options($)(2) Compensation ($)(3)
($) ($) ($)(1)
- ----------------------------------------------------------------------------------------------------------------------------
<s>
Trevor M. Hillman 2002 139,705 Nil 16,884 200,000 Nil
(Chairman and Chief
Executive Officer)
- ----------------------------------------------------------------------------------------------------------------------------
2001 102,935 Nil 10,900 Nil Nil
- ----------------------------------------------------------------------------------------------------------------------------
2000 73,799 17,500 7,908 237,500 Nil
- ----------------------------------------------------------------------------------------------------------------------------
Gregg C. Johnson 2002 139,705 Nil 6,000 200,000 Nil
(President and Chief
Operating Officer)
- ----------------------------------------------------------------------------------------------------------------------------
2001 58,541 Nil Nil Nil Nil
- ----------------------------------------------------------------------------------------------------------------------------
2000 26,110 Nil Nil 187,500 Nil
- ----------------------------------------------------------------------------------------------------------------------------
56
<page>
<caption>
- ----------------------------------------------------------------------------------------------------------------------------
Long Term
Compensation
- ----------------------------------------------------------------------------------------------------------------------------
Annual Compensation Awards
- ----------------------------------------------------------------------------------------------------------------------------
Name and Principal Fiscal Other Annual Securities Under All Other
Position Year Salary Bonus Compensation Options($)(2) Compensation ($)(3)
($) ($) ($)(1)
- ----------------------------------------------------------------------------------------------------------------------------
<s>
Ayaz Kara 2002 50,753 57,954 Nil Nil Nil
(Vice President,
Business Development)
- ----------------------------------------------------------------------------------------------------------------------------
2001 50,753 42,586 Nil 75,000 Nil
- ----------------------------------------------------------------------------------------------------------------------------
2000 50,753 28,021 Nil Nil Nil
- ----------------------------------------------------------------------------------------------------------------------------
Timothy J. 2002 104,376 Nil Nil 75,000 Nil
Sebastian
(Secretary) (4)
- ----------------------------------------------------------------------------------------------------------------------------
2001 86,251 Nil Nil Nil Nil
- ----------------------------------------------------------------------------------------------------------------------------
2000 Nil Nil Nil Nil Nil
- ----------------------------------------------------------------------------------------------------------------------------
</table>
(1) Relates to vehicle allowances. Perquisites and other personal
benefits do not exceed the lesser of $10,000 and 10% of the annual
salary for the named Executive Officer.
(2) See the two tables below.
(3) Perquisites and other personal benefits do not exceed the lesser of
$50,000 and 10% of the annual salary.
(4) Timothy J. Sebastian resigned as Secretary of the Corporation on
November 27, 2002 and was elected as a director of the Company on
November 27, 2002.
STOCK OPTIONS GRANTED
The following table details information with respect to the grant of stock
options to Trevor M. Hillman, Gregg C. Johnson, Ayaz Kara and Timothy J.
Sebastian during the fiscal year ended May 31, 2002.
<table>
<caption>
- -------------------------------------------------------------------------------------------------------------------------
Name
Securities % of Total Exercise or Market Value of Expiration Date
Under Option Options Granted Base Price Securities
Granted (#) to Employees in ($/Security) Underlying Options
Financial Year on the Date of
Grant ($/Security)
- -------------------------------------------------------------------------------------------------------------------------
<s>
Trevor M. Hillman 200,000 26.05 $1.80 $1.80 November 30, 2006
- -------------------------------------------------------------------------------------------------------------------------
57
<page>
<caption>
- -------------------------------------------------------------------------------------------------------------------------
<s>
Gregg C. Johnson 200,000 26.05 $1.80 $1.80 November 30, 2006
- -------------------------------------------------------------------------------------------------------------------------
Ayaz Kara Nil N/A N/A N/A N/A
- -------------------------------------------------------------------------------------------------------------------------
Timothy J. Sebastian 75,000 9.77% $1.80 $1.80 November 30, 2006
- -------------------------------------------------------------------------------------------------------------------------
</table>
The following table sets forth information with respect to all options exercised
by Trevor M. Hillman, Gregg C. Johnson, Ayaz Kara and Timothy J. Sebastian
during our most recently completed fiscal year and all options held and
outstanding by them on May 31, 2002.
<table>
<caption>
- -------------------------------------------------------------------------------------------------------------------------
Name Securities Aggregate Value Unexercised Options at Value of Unexercised in
Acquired on Realized Financial Year End the Money Options at
Exercise ($) (#) Financial Year End (1)<F1>
(#)
- -------------------------------------------------------------------------------------------------------------------------
<s>
Trevor M. Hillman Nil Nil 437,500 exercisable, NIL value
Nil unexercisable
- -------------------------------------------------------------------------------------------------------------------------
Gregg C. Johnson Nil Nil 387,500 exercisable, NIL value
Nil unexercisable
- -------------------------------------------------------------------------------------------------------------------------
Ayaz Kara Nil Nil 75,000 exercisable, NIL value
Nil unexercisable
- -------------------------------------------------------------------------------------------------------------------------
Timothy J. Sebastian Nil Nil 28,124 exercisable, NIL value
46,876 unexercisable
- -------------------------------------------------------------------------------------------------------------------------
<FN>
(1)<F1> This amount was determined by multiplying the number of Common Shares
issuable under such options by the closing price of the Common Shares
on the TSX on May 31, 2002 ($0.85) and subtracting therefrom the
product of the number of such Common Shares and the exercise price
thereof.
</FN>
</table>
EMPLOYMENT CONTRACTS / COMPENSATION IN THE EVENT OF TERMINATION OF CHANGE OF
CONTROL
TREVOR HILLMAN, CHIEF EXECUTIVE OFFICER, CHAIRMAN OF THE BOARD AND A DIRECTOR
We have a services agreement with TMH Holdings Ltd. ("TMH") for the
services of Trevor M. Hillman as our Chairman and Chief Executive
Officer. Pursuant to the agreement, we agreed to pay annually to TMH
the greater of $60,000 and an amount equal to 0.5% of the gross sales
actually achieved by us during each fiscal year provided that our
earnings before interest, taxes, depreciation and amortization exceeds
11% on an annualized basis.
The contract commenced on April 1, 2001 and ends on December 31, 2004
unless terminated earlier in accordance with the agreement. We may
terminate the agreement at any time for cause without payment of any
compensation either by way of anticipated earnings or damages. The
agreement may not otherwise be terminated earlier by us without the
consent of TMH. In the event of a change of control of VHQ
Entertainment, as defined in the agreement, TMH has the
58
<page>
right to terminate the agreement and be paid an amount equal to three
times the highest annual amount we paid to TMH during the three years
prior to the change of control.
GREGG C. JOHNSON, PRESIDENT AND CHIEF OPERATING OFFICER
We have a services agreement with Summit Capital Corporation ("Summit")
for the services of Gregg C. Johnson as our President and Chief
Operating Officer. Pursuant to the agreement, we agreed to pay annually
to Summit the greater of $60,000 and an amount equal to 0.5% of the
gross sales actually achieved by us during each fiscal year provided
that our earnings before interest, taxes, depreciation and amortization
exceeds 11% on an annualized basis.
The contract commenced on April 1, 2001 and ends on December 31, 2004
unless terminated earlier in accordance with the agreement. We may
terminate the agreement at any time for cause without payment of any
compensation either by way of anticipated earnings or damages. The
agreement may not otherwise be terminated earlier by us without the
consent of Summit. In the event of a change of control of VHQ
Entertainment, as defined in the agreement, Summit has the right to
terminate the agreement and be paid an amount equal to three times the
highest annual amount we paid to Summit during the three years prior to
the change of control.
MARC GIGNAC, DIRECTOR OF OPERATIONS, SASKATCHEWAN
We have an employment contract with Marc Gignac for his services as our
Director of Operations, Saskatchewan. Pursuant to the agreement, we
agreed to pay annually to Marc Gignac $50,000 plus a quarterly bonus of
1% of gross sales generated by our subsidiary, Star Vision Enterprises
Ltd.
The agreement commenced on December 1, 1999 and is for a term of three
years unless terminated earlier in accordance with the agreement. The
agreement may be terminated by us at any time for cause without payment
of any compensation either by way of anticipated earnings or damages.
If the agreement is terminated earlier by us without cause, Marc Gignac
is entitled to 12 months notice or 12 months salary in lieu of notice.
There are no change of control provisions in the agreement. The Company
is currently reviewing Mr. Gignac's contract.
DERREK R. WONG, SENIOR VICE PRESIDENT OF FINANCE AND CHIEF FINANCIAL OFFICER
To date, we have not entered into a written employment agreement with
Mr. Wong for his services as our Senior Vice President of Finance and
Chief Financial Officer.
MICHAEL D. MCKELVIE, SENIOR VICE PRESIDENT OF MARKETING AND COMMUNICATIONS
To date, we have not entered into a written employment agreement with
Mr. McKelvie for his services as our Senior Vice President of Marketing
and Communications.
None of our Directors or executive officers received other compensation in
excess of the lesser of US$25,000 or 10% of such officer's cash compensation as
reported in the above table and all Directors and executive officers, as a
group, did not receive other compensation which exceeded US$25,000 times the
number of persons in the group or 10% of the compensation reported in the table
set forth above.
59
<page>
Except as set out above, we have no material bonus or profit sharing plans
pursuant to which cash or non-cash compensation is or may be paid to our
Directors or executive officers.
BOARD PRACTICES
All of the members of our Board of Directors are elected by the shareholders and
hold office until their successors are duly elected and qualified, unless they
sooner resign or cease to be Directors in accordance with our Articles. At our
annual general meeting on November 22, 1999, our shareholders approved an
amendment to our Articles of Incorporation to increase the terms of our
Directors to up to three years. It is current practice to elect directors for
one-year terms only.
At the November 27, 2002 meeting, all the Directors were elected to one year
terms. Members of our Board of Directors are elected by the holders of our
common shares to represent the interests of all shareholders. The Board of
Directors meets periodically to review significant developments affecting us and
to act on matters requiring Board approval. Although the Board of Directors
delegates many matters to others, it reserves certain powers and functions to
itself. Currently, the Board of Directors has appointed an Audit Committee, a
Compensation Committee and a Corporate Governance and Nominating Committee.
The Audit Committee is directed to review the scope, cost and results of the
independent audit of our books and records; the results of the annual audit with
management and the adequacy of our accounting, financial and operating controls;
to recommend annually to the Board of Directors the selection of the independent
auditors; to consider proposals made by our independent auditors for consulting
work; and to report to the Board of Directors, when so requested, on any
accounting or financial matters. Except as noted above in this section, none of
our Directors or executive officers is a party to any arrangement or
understanding with any other person pursuant to which said individual was
elected as a Director or officer of the Company.
The Corporate Governance Committee is charged with the responsibility of
ensuring that our Board of Directors has effectively implemented policies
regarding the Board's responsibility for the stewardship of VHQ Entertainment
including:
(i) the adoption of a corporate strategy;
(ii) the adoption, on an annual basis, of the corporate objectives
which the Chief Executive Officer and our senior officers are
responsible for meeting;
(iii) management succession planning;
(iv) a communications program for VHQ Entertainment;
(v) the integrity of our internal control and management
information systems;
(vi) guidelines whereby individual Directors can engage outside
advisors at the expense of VHQ Entertainment;
60
<page>
(vii) reviewing and recommending to the Board for approval, the
corporate governance report for inclusion in the Annual
Report and, when necessary, for inclusion in our Annual
Information Circular;
(viii) requesting and receiving such information with regards to our
affairs as the Committee may consider necessary and
appropriate to carry out its duties and responsibilities;
(ix) reporting to the Board at least once a year and when otherwise
required; and
(x) at the request of the Board, considering any other matters
which would assist the Directors in meeting the corporate
governance responsibilities or adhering to any governance
guidelines established by the relevant regulatory bodies.
The Compensation and Nominating Committee is charged with the responsibility
of setting and overseeing the compensation of our Directors and executive
officers including:
(i) determining the amount and kind of compensation;
(ii) reviewing and recommending the executive compensation report
to the Board for approval and inclusion in the Annual Report,
and when necessary, in the annual Information Circular;
(iii) requesting and receiving such information and explanations
with regard to our affairs as the Committee may consider
necessary and appropriate to carry out its duties and
responsibilities;
(iv) reporting to the Board as required and at least once per year;
and
(v) at the request of the Board, considering any other matters
which would assist the Directors in meeting the corporate
governance responsibilities or adhering to any governance
guidelines established by the relevant regulatory bodies.
OUR EMPLOYEES
As of October 31, 2002, we employed approximately 430 employees, including 5
employees in senior management, 8 employees in operations/mid-level management,
61 employees in operations/store-level management, 8 employees in head office
administration, and approximately 353 employees who service our customers in our
video and home entertainment stores. A majority of our employees are either
permanent part-time or part-time employees.
61
<page>
The following is a breakdown of the average number of employees we employed by
geographic location over the last three fiscal years and the three month period
ended August 31, 2002:
<table>
<caption>
-----------------------------------------------------------------------
AVERAGE NUMBER OF EMPLOYEES DURING:
GEOGRAPHIC LOCATION
- ------------------------------------------------------------------------------------------------------------
THE TWELVE MONTH THE TWELVE MONTH THE TWELVE MONTH
PERIOD ENDED PERIOD ENDED MAY 31, PERIOD ENDED MAY 31,
MAY 31, 2000 2001 2002
- ------------------------------------------------------------------------------------------------------------
<s>
Alberta 260 330 330
- ------------------------------------------------------------------------------------------------------------
Saskatchewan 75 90 81
- ------------------------------------------------------------------------------------------------------------
Northwest Territory 10 13 9
- ------------------------------------------------------------------------------------------------------------
TOTAL 345 433 420
- ------------------------------------------------------------------------------------------------------------
</table>
None of our employees are subject to collective bargaining agreements, and we
believe we have a positive relationship with our employees. Management has made
a priority of continuing to improve employer/employee relationships and has
recently added a number of employee incentive initiatives, including stock
options and selective cash compensation in an effort to decrease rates of
employee turnover. Over the course of fiscal 2002, rates of employee turnover
decreased yet such rates are still high relative to industry comparables.
Management is conducting further investigations into this matter in an effort to
reduce employee turnover rates.
SHARE OWNERSHIP
Beneficial Share Ownership of Our Directors and Senior Management
62
<page>
The following table sets forth the beneficial ownership of our Directors and
senior management as at November 30, 2002:
<table>
<caption>
- --------------------------------------------------------------------------------------------------------------------
IDENTITY OF NUMBER OF COMMON SHARES OWNED
PERSONS OR GROUP BENEFICIALLY OR SUBJECT TO CONTROL PERCENTAGE OF CLASS
OR DIRECTION(1)
- --------------------------------------------------------------------------------------------------------------------
<s>
TREVOR M. HILLMAN, Director and 2,383,513 16.33%
CEO
Red Deer, Alberta (2)
- --------------------------------------------------------------------------------------------------------------------
GREGG C. JOHNSON, President and 1,346,918 9.22%
Chief Operating Officer
Red Deer, Alberta (3)
- --------------------------------------------------------------------------------------------------------------------
AYAZ KARA, Vice-President, 551,235 3.77%
Business Development
Calgary, Alberta (4)
- --------------------------------------------------------------------------------------------------------------------
MICHAEL D. MCKELVIE, Senior 33,334 less than 1%
Vice-President, Marketing &
Communications
Calgary, Alberta (5)
- --------------------------------------------------------------------------------------------------------------------
MARC L. GIGNAC, Director of 1,076,000 7.37%
Operations, Saskatchewan
Saskatoon, Saskatchewan (6)
- --------------------------------------------------------------------------------------------------------------------
PETER A. LACEY, Director 284,728 1.95%
Red Deer, Alberta (7)
- --------------------------------------------------------------------------------------------------------------------
CATHERINE J. MCDONOUGH, Director 104,147 less than 1%
Red Deer, Alberta (8)
- --------------------------------------------------------------------------------------------------------------------
DERREK R. WONG, Senior Vice 83,333 less than 1%
President of Finance, Chief
Financial Officer
Olds, Alberta (9)
- --------------------------------------------------------------------------------------------------------------------
TIMOTHY J. SEBASTIAN 75,000 less than 1%
Director
Edmonton, Alberta (10)
- --------------------------------------------------------------------------------------------------------------------
GORDON HILLMAN, Director (11) 1,225,596 8.39%
Red Deer, Alberta
- --------------------------------------------------------------------------------------------------------------------
OFFICERS AND DIRECTORS, 7,163,804 49.07%
AS A GROUP
- --------------------------------------------------------------------------------------------------------------------
</table>
Notes: (1)The figures reflect both shares actually owned and options
and/or warrants held by each individual that are exercisable
within 60 days of November 30, 2002.
(2)Includes options to acquire 437,500 shares of common stock
and warrants to acquire 11,382 common shares, exercisable
within 60 days of November 30, 2002 and 300,583 shares (and an
additional 27,083 options exercisable within 60 days of
November 30, 2002) held by his spouse.
(3)Includes options to acquire 387,500 shares of common stock
and warrants to acquire 11,382 common shares, exercisable
within 60 days of November 30, 2002.
63
<page>
(4)Includes options to acquire 75,000 shares of common stock
and warrants to purchase 22,764 common shares, exercisable
within 60 days of November 30, 2002 and 225,000 shares held by
his spouse.
(5)Includes options to acquire 33,334 common shares exercisable
within 60 days of November 30, 2002.
(6)512,000 shares (including options to acquire 52,500 shares of
common stock and 5,961 warrants to purchase common shares,
exercisable within 60 days of November 30, 2002) are held by
Marc Gignac, while his wife, Giselle Gignac, holds 498,000
shares. Does not include a $17,073 three year 8% convertible
debenture granted by the Company in favor of Mr. Gignac's
holding company, which such debenture is convertible for the
first two years at $2.50 per share and in the third year at
$3.00 per share.
(7)Includes shares owned by Summerhill Investment Corporation,
a private company in which Mr. Lacey owns 50% of the shares
and his wife owns the remaining 50% of the shares, includes
options to acquire 102,500 common shares and warrants to
acquire 22,764 common shares exercisable within 60 days of
November 30, 2002. Does not include a $409,752 three year 8%
convertible debenture granted by the Company in favor of Mr.
Lacey and his family members, which such Debenture is
convertible for the first two years at $2.50 per share and in
the third year at $3.00 per share.
(8)Includes options to purchase 52,500 common shares and warrants
to purchase 11,382 common shares, exercisable within 60 days
of November 30, 2002.
(9)Includes options to purchase 75,000 common shares exercisable
within 60 days of November 30, 2002.
(10)Includes options to purchase 83,333 common shares exercisable
within 60 days of November 30, 2002.
(11)Includes options to purchase 10,083 common shares exercisable
within 60 days of November 30, 2002.
(12)Includes warrants to acquire 56,910 common shares exercisable
within 60 days of November 30, 2003.
The following table sets out the options granted (both vested and non-vested) to
each individual listed above (as at November 30, 2002).
<table>
<caption>
- ---------------------------------------------------------------------------------------------------------------
OPTIONEE POSITION NUMBER OF PRICE EXPIRY DATE
OPTIONS
- ---------------------------------------------------------------------------------------------------------------
<s>
Trevor M. Hillman CEO, Chairman & Director 237,500 $1.51 January 19, 2005
200,000 $1.80 November 30, 2006
- ---------------------------------------------------------------------------------------------------------------
Gregg C. Johnson Chief Operating Officer, 187,500 $1.51 January 19, 2005
President & Director 200,000 $1.80 November 30, 2006
- ---------------------------------------------------------------------------------------------------------------
Ayaz Kara Vice President, Business 75,000 $1.51 January 19, 2005
Development
- ---------------------------------------------------------------------------------------------------------------
Catherine J. McDonough Director 50,000 $1.51 January 19, 2005
10,000 $1.80 November 30, 2006
- ---------------------------------------------------------------------------------------------------------------
Peter A. Lacey Director 100,000 $1.51 January 19, 2005
10,000 $1.80 November 30, 2006
- ---------------------------------------------------------------------------------------------------------------
Derrek R. Wong Senior Vice President 150,000 $1.80 November 30, 2006
Finance, Chief Financial
Officer
- ---------------------------------------------------------------------------------------------------------------
Marc L. Gignac President of Subsidiary, 50,000 $1.51 January 19, 2005
Director of Operations, 10,000 $1.80 November 30, 2006
Saskatchewan
- ---------------------------------------------------------------------------------------------------------------
64
<page>
<caption>
- ---------------------------------------------------------------------------------------------------------------
<s>
Michael D. McKelvie Senior Vice President, 50,000 $2.68 September 20, 2005
Marketing and
Communications
- ---------------------------------------------------------------------------------------------------------------
Timothy J. Sebastian Director 75,000 $1.80 November 30, 2006
- ---------------------------------------------------------------------------------------------------------------
Employees (as a group) 150,000 $1.50 January 19, 2005
19,800 $2.68 September 20, 2005
52,500 $1.80 November 30, 2006
- ---------------------------------------------------------------------------------------------------------------
TOTAL 1,627,300
- ---------------------------------------------------------------------------------------------------------------
</table>
OUR INCENTIVE STOCK OPTION PLAN
STOCK OPTIONS
Two million three hundred and fifty two thousand (2,352,000) shares of common
stock are reserved for the issuance of stock options pursuant to our stock
option plan (the "Plan"). The Plan provides that the Directors, subject to the
price restrictions and other requirements of the Toronto Stock Exchange, or any
other Exchange our stock may become listed on, shall fix the terms of the
options and the option price. The Plan also provides that no option shall be
granted to any person except upon the recommendation of our Directors, and only
Directors, officers, employees, and other persons providing on-going services
are eligible for stock option grants. Stock options granted under the Plan may
not be for a period longer than ten (10) years and the exercise price must be
paid in full upon exercise of the option.
As of October 31, 2002, there were outstanding options to purchase a total of
1,677,300 common shares under the Plan. The following table sets out details of
the current plan with respect to all such stock options:
65
<page>
<table>
<caption>
- ---------------------------------------------------------------------------------------------------------------------
NAME OF SHARES
GROUP DATE OF GRANT UNDER OPTION EXERCISE PRICE EXPIRATION DATE
- ---------------------------------------------------------------------------------------------------------------------
<s>
Executive Officers January 19, 2000 500,000 $1.51 January 19, 2005
September 20, 2000 50,000 $2.68 September 20, 2005
November 30, 2001 635,000 $1.80 November 30, 2006
- ---------------------------------------------------------------------------------------------------------------------
Directors who are not January 19, 2005
Executive Officers January 19, 2000 200,000 $1.51 November 30, 2006
November 30, 2001 20,000 $1.80
- ---------------------------------------------------------------------------------------------------------------------
Employees January 19, 2000 150,000 $1.51 January 19, 2005
September 20, 2000 19,800 $2.68 September 20, 2005
November 30, 2001 52,500 $1.80 November 30, 2006
- ---------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------
TOTAL 1,627,300
- ---------------------------------------------------------------------------------------------------------------------
</table>
EMPLOYEE SHARE PURCHASE PLAN
Effective October 10, 2001, our Board of Directors adopted an Employee Share
Purchase Plan. The Employee Share Ownership Plan was ratified and approved by
our shareholders at an annual meeting held November 15, 2001. Pursuant to the
terms of the Employee Share Ownership Plan, officers, directors, consultants and
certain employees, may purchase shares of our common stock at market prices,
with the purchaser and VHQ Entertainment each paying one-half of the purchase
price. We can reserve up to 600,000 shares up to November 30, 2002 for issuance
at any one time pursuant to the Employee Share Ownership Plan. As at November
30, 2002, 5,756 shares were issued under this plan.
ITEM 7. MAJORITY SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
MAJORITY SHAREHOLDERS
We are currently a publicly held corporation, with our common shares held by
residents of Canada, the United States and other countries. To the best of our
knowledge, we are not controlled, directly or indirectly, by another
corporation, any government or any natural or legal person, severally or
jointly.
As of November 30, 2002, no person or corporation or other entity owns, directly
or indirectly, or controls more than 5% of our common shares, the only class of
securities with voting rights, except for the persons or groups listed below:
66
<page>
<table>
<caption>
- -----------------------------------------------------------------------------------------------------------------------
IDENTITY OF NUMBER OF COMMON SHARES OWNED BENEFICIALLY
PERSONS OR GROUP OR SUBJECT TO CONTROL OR DIRECTION PERCENTAGE OF CLASS
- -----------------------------------------------------------------------------------------------------------------------
<s>
TREVOR M. HILLMAN, Director, 16.23%
Chairman and CEO 2,371,013 (1)<F1>
Red Deer, Alberta
- -----------------------------------------------------------------------------------------------------------------------
GREGG C. JOHNSON, Director, President 9.22%
and Chief Operating Officer 1,346,918 (2)<F2>
Red Deer, Alberta
- -----------------------------------------------------------------------------------------------------------------------
MARC L. GIGNAC, Director and 1,076,000 (3)<F3> 7.37%
Director of Operations
Saskatoon, Saskatchewan
- -----------------------------------------------------------------------------------------------------------------------
TIMOTHY G. HILLMAN 881,633 (4)<F4> 6.04%
Red Deer, Alberta
- -----------------------------------------------------------------------------------------------------------------------
TARI D. GERVAIS 878,500 (4)<F4> 6.01%
Red Deer, Alberta
- -----------------------------------------------------------------------------------------------------------------------
TRACY D. BARKER 849,417 (5)<F5> 5.82%
Red Deer, Alberta
- -----------------------------------------------------------------------------------------------------------------------
GORDON HILLMAN 1,225,596 (6)<F6> 8.39%
Red Deer, Alberta
- -----------------------------------------------------------------------------------------------------------------------
<FN>
Notes: (1)<F1>Includes options to acquire 437,500 shares of common stock
and warrants to purchase 22,764 common shares, exercisable
within 60 days of November 30, 2002, and 300,583 shares (and
27,083 options exercisable within 60 days of November 30,
2002) held by his spouse.
(2)<F2>Includes options to acquire 387,500 shares of common stock and
warrants to purchase 11,382 shares of common stock,
exercisable within 60 days of November 30, 2002.
(3)<F3>Includes options to acquire 52,500 shares of common stock
and warrants to purchase 5,961 common shares, exercisable
within 60 days of November 30, 2002 are held by Marc Gignac,
and 498,000 shares owned by Mr. Gignac's wife. Does not
include a $17,073 three year 8% convertible debenture granted
by the Company in favor of Mr. Gignac's holding company, which
such debenture is convertible for the first two years at $2.50
per share and in the third year at $3.00 per share.
(4)<F4>Includes options to acquire 50,833 shares of common stock
exercisable within 60 days of November 30, 2002.
(5)<F5>Includes options to acquire 25,417 shares of common stock
exercisable within 60 days of November 30, 2002.
(6)<F6>Includes warrants to purchase 59,910 common shares within 60
days of November 28, 2002.
</FN>
</table>
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None of the above shareholders have different voting rights than our other
shareholders.
There are no arrangements, known to us, that may at a subsequent date result in
a change in our control.
UNITED STATES SHAREHOLDERS
Based on the records of the Montreal Trust, our registrar and transfer agent, at
May 31, 2002, there were two holders of record of our common shares with United
States addresses who collectively held 67,630 shares, or less than 1% of the
12,538,559 issued and outstanding shares. Our records indicate that, as of
October 31, 2002, there were no holders of record of stock options or warrants
with United States addresses. Based on the mailing requests received from the
various depositories and "street name" holders, the Company estimates that there
are approximately 700 beneficial holders of whom less than 1% appear to be
resident in or have U.S. mailing addresses. As noted above, we are not in a
position to confirm ownership by these parties.
RELATED PARTY TRANSACTIONS
Other than as disclosed below, except for the ownership of our securities and
the compensation described herein, and advances of $190,000 by certain officers
to cover expenses and advances of $75,000 to certain officers, all of which were
reimbursed or repaid, for the three years ended May 31, 2002 and the period from
June 1, 2002 to October 31, 2002, we have not entered into any transactions or
loans between us and any (a) enterprises that directly or indirectly through one
or more intermediaries, control or are controlled by, or are under common
control with, VHQ Entertainment; (b) associates; (c) individuals owning,
directly or indirectly, an interest in the voting power of VHQ Entertainment
that gives them significant influence over VHQ Entertainment, and close members
of any such individuals' family; (d) key management personnel and close members
of such individuals' families; or (e) enterprises in which a substantial
interest in the voting power is owned, directly or indirectly by any person
described in (c) or (d) or over which such a person is able to exercise
significant influence.
None of our insiders, proposed nominees for election as our Directors or their
associates and affiliates, has any material interest in any transaction with us
since June 1, 1998, which has not been previously disclosed in this Registration
Statement on Form 20-F except as follows:
1. We acquired Integrated Retail from, among others, Trevor H. Hillman,
our Chief Executive Officer and a member of our Board of Directors and
Gregg Johnson, our President, Chief Operating Officer and a member of
our Board of Directors. See "Item 4. Information on the Company - Our
Acquisitions - Our Acquisition of Integrated Retail." This was not an
arms' length transaction.
2. A Nevada corporation, E-Trend Networks, Inc. (formerly The
MovieSource.com Corp.), was incorporated April 29, 1999, to engage in
the e-commerce sale and distribution of filmed entertainment, music and
video games. E-Trend Networks issued shares for nominal consideration
to Trevor H. Hillman (5.65%), our Chief Executive Officer and a member
of our Board of Directors, Gregg C. Johnson (5.65%), our President and
Chief Operating Officer and a member of our Board of Directors, and
Ayaz Kara (less than
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1%), our Vice President - Business Development and a member of our
Board of Directors from November 22, 1999 to June 5, 2002.
In January 2000, E-Trend acquired Langara Distribution Inc., a Canadian
based wholesaler of music, to support its music title fulfillment
operations. E-Trend uses Langara Distribution Inc. to provide music
procurement and fulfillment for its own network web site and provide
similar services for other Internet based businesses.
On February 22, 2001, E-Trend was acquired by Cool Entertainment Inc.,
a Delaware corporation formerly quoted for trading on the NASD
over-the-counter bulletin board ("Cool"). As a result of the
acquisition, the shareholders of E-Trend became the controlling
shareholders of Cool, Cool changed its name to E-Trend Networks, Inc.
On December 26, 2001, we entered into an agreement to sell our entire
holdings in E-Trend, being 2,000,000 shares of common stock, to The
Game Holdings, Ltd., a British Virgin Islands Corporation, for US$0.40
per share, for an aggregate purchase price of US$800,000. The purchase
price will be payable over 18 months pursuant to a secured Promissory
Note delivered by The Game Holdings, Ltd. as follows:
(a) US$10,000 per month from January, 2002 until March,
2002;
(b) US$30,000 per month from April, 2002 until May 31,
2003; and
(c) the remainder of the purchase price will be paid on
June 30, 2003.
The Promissory Note bears interest at a rate of 6% per annum. The
Promissory Note was to be secured by way of a second charge
registration against a yacht owned by The Game Holdings, Ltd. which as
at June 22, 2001 had an estimated market value of approximately
US$1,600,000 and a replacement value of approximately US$2,000,000 as
determined by an independent appraiser, the appraisal of which was
delivered by the purchaser. See "Item 4 - Information on the Company -
E-Trend Networks, Inc." To date, the Company has not received any
payments from Game Holdings as required by the terms of the promissory
note. As the payments are received, a gain on the sale will be
recognized.
We currently rent office space in Calgary, Alberta to E-Trend Networks
in our marketing and accounting office facility.
3. On September 29, 1999, we completed our acquisition of Safiqa Holdings
Ltd., an independent video retailer operating four video superstores in
the Calgary market under the trade name "Rainbow Video." Ayaz Kara, the
President of Safiqa Holdings Ltd, is now our Vice President, Operations
and was a member of the Board of Directors from November 22, 1999 to
June 5, 2002. See "Item 4. Information on the Company - Our
Acquisitions - Our Acquisition of Rainbow Video."
4. On December 1, 1999, we completed our acquisition of Star Vision
Enterprises Inc., an independent video retailer operating six video and
home entertainment superstores in the Saskatoon market. Marc Gignac,
President and Director of Star Vision, is now the Director -
Operations, Saskatchewan for us and was a Director of the Company to
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November 27, 2002. See "Item 4. Information on the Company - Our
Acquisitions - Our Acquisition of Star Vision."
5. We lease our principal office and warehouse facility in Red Deer,
Alberta from G&J Holdings Inc., a company controlled by Gordon Hillman,
the father of Trevor H. Hillman, our Chief Executive Officer and a
member of our Board of Directors. The lease is for a five year term
commencing March 27, 1998. The rent payable in each year is as follows:
(a) year one $3,723.96 per month;
(b) year two $4,010.42 per month;
(c) year three $4,296.88 per month;
(d) year four $4,583.33 per month;
(e) year five $4,869.79 per month.
We are also responsible for operational costs under the lease. The
lease is renewable for two further five year terms under the same terms
and conditions and at a rental rate based on a current rental market in
the City of Red Deer, in the Province of Alberta. See "Item 4.
Information on the Company - Our Properties and Equipment."
6. In January of 2000, we completed a revenue sharing agreement whereby
we sold certain capital assets of Integrated Retail Corp.
("Integrated") to Video Limited Partnership. See "Item 4 - Information
on the Company - Business Overview - Licenses/Source Agreements -
Revenue Sharing Arrangement - Video Limited Partnership." Holders of
the Limited Partnership Units included the following insiders of VHQ
Entertainment: Trevor Hillman, our Chief Executive Officer and a
Director, who owned or controlled (directly or through his family) 20%
of the Limited Partnership Units; Peter Lacey, a Director of VHQ
Entertainment who owned or controlled approximately 18.75% of the
units; Ayaz Kara, Vice President - Business Development (and a Director
from November 22, 1999 to June 5, 2002), who owned 2.5% of the Units;
and Catherine McDonough, a Director who owned approximately 2.5% of the
units. Other insiders of VHQ Entertainment including Tari Gervais and
Timothy Hillman, employees of VHQ Entertainment, Gregg Johnson,
President and Chief Operating Officer and a Director of VHQ
Entertainment, and Howard Bolinger, our former Chief Financial Officer,
own an aggregate of 3.1% of the Limited Partnership Units.
Effective December 1, 2001, we acquired all of the outstanding Limited
Partnership Units from the Video Limited Partners. The Video Limited
Partners had the option to receive units of VHQ Entertainment comprised
of one common share and one-half of a share purchase warrant
exercisable at any time over the next two years at $2.00 per share; or
an 8% three year subordinated convertible debenture. The convertible
debenture is convertible into common shares of VHQ Entertainment at
$2.50 for two years and $3.00 for the final year. As a result of the
acquisition of the Limited Partnership Units, we issued 546,336 common
shares and 273,168 warrants and $1,280,475 worth of debentures. Trevor
Hillman received 22,764 common shares and 11,382 warrants; Gregg
Johnson received 22,764 common shares and 11,382 warrants; Marc Gignac
(through his holding company) received 11,382 common shares and 5,691
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warrants, and $17,073 of the convertible debenture; Peter Lacey
received 45,528 common shares, 22,764 warrants, and $341,460 worth of
the convertible debenture; Ayaz Kara received 45,528 common shares and
22,764 warrants; Catherine McDonough received 22,764 shares and 11,382
warrants.
Except for our acquisition of Integrated Retail, we believe that the
transactions described above were on terms as favorable as we would have
obtained from non-related third parties at arms' length.
No individual who is, or at any time during the last three completed fiscal
years and to the present was, a Director, executive officer or senior officer of
VHQ Entertainment, nor any proposed nominee for election as a Director of VHQ
Entertainment, nor any associate of any one of them:
a. is, or at any time during the last three completed fiscal
years and to the present has been, indebted to us or any of
our subsidiaries; or
b. was indebted to another entity, which such indebtedness is, or
was at any time during our last three completed fiscal years
and to the present, the subject of a guarantee, support
agreement, letter of credit or other similar arrangement or
understanding provided by us or any of our subsidiaries.
ITEM 8. FINANCIAL INFORMATION
CONSOLIDATED STATEMENTS AND OTHER FINANCIAL INFORMATION
SEE PAGES BEGINNING WITH PAGE F-1.
SIGNIFICANT CHANGES
None
LEGAL PROCEEDINGS
On January 18, 2001, Beamscope Canada, Inc. ("Beamscope"), who had previously
supplied us with video game rental products, filed a statement of claim in the
Superior Court of Justice in Ontario, Canada. The claim alleges that Beamscope
is owed $159,074.56 for video games and related merchandise provided to us from
August 2000 to November 2000. We have filed a counterclaim against Beamscope
seeking $1,500,000 in damages for lost business as a result of Beamscope's
failure to deliver products in a timely manner. As of April 1, 2002 the parties
have agreed to settle the claim by the payment from us to Beamscope in the
amount of $50,000 for a full release by both sides. As of the date of this
annual report, the $50,000 has not been paid.
On January 2, 2002, Brian Meyer filed a statement of claim against us and
E-Trend Networks, Inc. in the Court of Queen's Bench, Alberta, Judicial District
of Red Deer. Mr. Meyer claims that he was improperly terminated and is seeking a
judgment in the amount of $30,750 and general/punitive damages in the amount of
$25,000, plus interests and costs. On January 29, 2002, we filed a Statement of
Defence
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as well as a counterclaim in the amount of $5,000 for a loan we made to Mr.
Meyer which has not been repaid. We intend to defend against Mr. Meyer's claim.
To the best of our knowledge, we are not subject to any other active or pending
legal proceedings or claims against us or any of our subsidiaries. However, from
time to time, we may become subject to additional claims and litigation
generally associated with any business venture.
DIVIDEND POLICY
We have not paid any dividends on our common shares and do not intend to pay
dividends on our common shares in the immediate future. Any decision to pay
dividends on our common shares in the future will be made by our board of
directors on the basis of earnings, financial requirements and other such
conditions that may exist at that time.
ITEM 9. LISTING
NATURE OF TRADING MARKET
Our common shares have traded on the Toronto Stock Exchange ("TSX") under the
symbol "VHQ" since July 24, 2001. Our shares traded on the Canadian Venture
Exchange (formerly The Alberta Stock Exchange) from September 18, 1998 until
July 30, 2001 when we voluntarily delisted from the TSX Venture Exchange
(formerly the CDNX) as a result of our TSX listing. Set forth below are the
trading prices for our common shares on the TSX Venture Exchange and the TSX
monthly for the last six months and quarterly for completed financial years
since the start of trading.
THE CANADIAN VENTURE EXCHANGE
(FORMERLY THE ALBERTA STOCK EXCHANGE)
------------------------------------------------------------------------------
1998 HIGH (CDN$) LOW (CDN$) ACTUAL VOLUME
------------------------------------------------------------------------------
3rd Quarter (1) $0.98 $0.50 185,833
4th Quarter $1.10 $0.50 184,617
------------------------------------------------------------------------------
------------------------------------------------------------------------------
1999 HIGH (CDN$) LOW (CDN$) ACTUAL VOLUME
------------------------------------------------------------------------------
1st Quarter $0.98 $0.50 358,333
2nd Quarter $1.10 $0.50 197,000
3rd Quarter $1.00 $0.69 114,467
4th Quarter $1.75 $0.50 590,933
------------------------------------------------------------------------------
------------------------------------------------------------------------------
2000 HIGH (CDN$) LOW (CDN$) ACTUAL VOLUME
------------------------------------------------------------------------------
1st Quarter $2.50 $1.30 475,950
2nd Quarter $2.50 $1.65 134,946
3rd Quarter $5.25 $1.85 839,657
4th Quarter $3.60 $2.65 229,056
------------------------------------------------------------------------------
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-------------------------------------------------------------------------------
2001 HIGH (CDN$) LOW (CDN$) ACTUAL VOLUME
-------------------------------------------------------------------------------
1st Quarter $3.04 $2.00 449,766
2nd Quarter $2.40 $1.90 418,830
3rd Quarter $3.00 $1.80 97,130
4th Quarter $2.45 $1.65 468,893
-------------------------------------------------------------------------------
(1) Delisted from the TSX Venture Exchange as a result of listing on the Toronto
Stock Exchange on July 27, 2001.
THE TORONTO STOCK EXCHANGE
- --------------------------------------------------------------------------------
2002 HIGH (CDN$) LOW (CDN$) ACTUAL VOLUME
1st Quarter $1.95 $1.40 621,803
April $1.53 $0.90 943,555
May $1.15 $0.75 916,300
June $0.85 $0.62 641,795
July $0.75 $0.50 635,000
August $0.83 $0.62 346,900
September $0.80 $0.50 248,927
October $0.80 $0.38 349,902
November $0.65 $0.40 174,474
- --------------------------------------------------------------------------------
The closing sales price of our common shares on the Toronto Stock Exchange was
$0.45 on December 13, 2002.
Our common shares, no par value, are issued in registered form.
ITEM 10. ADDITIONAL INFORMATION
MEMORANDUM AND ARTICLES OF ASSOCIATION
REGISTER & CORPORATE PURPOSE
CORPORATE REGISTRATION
We are a corporation currently registered in Canada under the Canada Business
Corporations Act # 384084-1.
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PURPOSE
Our Articles of Continuance, at Section 6, allow us to carry on any and all
legal business activities without limitation. Currently, we operate, though
wholly-owned subsidiaries, a chain of 49 video and home entertainment stores in
Western Canada and the North West Territories. Our business strategy focuses on
serving markets in smaller urban centers, which typically have less competition,
lower fixed costs and lower overhead.
DIRECTOR POWERS & QUALIFICATIONS
INTERESTED TRANSACTION
Under Section 6.01 of our Bylaws, a Director who (i) is a party to, (ii) is a
Director or officer, or (iii) has a material interest in any person who is a
party to a material contract or proposed material contract with us or our
subsidiary must disclose the nature and extent of his interest. However, the
Director is not disqualified from voting in the transaction unless required by
the Canada Business Corporations Act.
BOARD COMPENSATION
Subject to any unanimous shareholder agreements, the Board has the power to vote
compensation to themselves or any member of their body without requiring an
independent quorum.
BORROWING POWER
Our Directors, without authorization of the shareholders, may: (i) borrow money
on the credit of the Company, (ii) issue, reissue, sell or pledge debt
obligations of the Company, (iii) subject to the Canada Business Corporations
Act, give a guarantee on behalf of the Company to secure performance of an
obligation of any person, and (iv) mortgage, hypothecate, pledge or otherwise
create a security interest in all or any property of the Company, owned or
subsequently acquired, to secure any obligation of the Company. These borrowing
powers may be varied by amendment of the Articles of Continuance.
DIRECTOR AGE LIMIT REQUIREMENT
There is currently no age limitation in place for Director positions.
NUMBER OF SHARES REQUIRED FOR DIRECTOR QUALIFICATION.
Our Directors are not required to hold any of our shares to qualify as a
Director.
RIGHTS AND PREFERENCES OF SHARES
COMMON SHARES
All common shares are of the same class and have the same rights, preferences
and limitations. Holders of common shares are entitled to receive dividends in
cash, property or shares when and if dividends are declared by the Board of
Directors out of funds legally available therefor. There are no limitations on
the payment of dividends. A quorum for a general meeting of shareholders is not
less than two persons
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holding not less than 5% of the shares entitled to be voted at the meeting.
Holders of common shares are entitled to one vote per share. Upon any
liquidation, dissolution or winding up of our business, the surplusif any, after
payment or provision for payment of all our debts, obligations or liabilities
shall be distributed to the holders of common shares. There are no pre-emptive
rights, subscription rights, conversion rights and redemption provisions
relating to the common shares and none of the common shares carry any liability
for further calls. At our last annual general meeting of shareholders, all of
our Directors were elected to serve one year terms; however, the Directors can
be appointed to serve staggered intervals.
The rights of holders of common shares may not be modified other than by a vote
of the majority of the common shares voting on such modification
Shareholders may apply to a court of competent jurisdiction for various remedies
on the ground that our affairs are being conducted in a manner oppressive to one
or more of the shareholders or that some resolution of shareholders has been
passed or is proposed that is unfairly prejudicial to one or more of the
shareholders. That Court may, with a view to bringing it to an end or to
remedying the matters complained of, make an interim or final order if it
considers appropriate.
There are no restrictions on the purchase or redemption of common shares by us
while there is any arrearage in the payment of dividends or sinking fund
installments.
PREFERRED STOCK
Our Board of Directors is authorized to issue such series of Preferred Stock as
they shall authorize. The terms of any dividend payment may be set by the Board
upon issuance of a given series. However, all Preferred Stock will have a
preference in dividends over any Common Stock and any other securities made
expressly junior to the Preferred Stock. In the event of a liquidation, the
Preferred Stock will be entitled to any surplus remaining after all debts and
senior securities have been paid. All dividend arrearages on Preferred Stock
will be paid before any distributions are made to Common Stock. The Board may
set such pre-emptive rights, subscription rights, conversion rights and
redemption provisions relating to the preferred shares and set liability for
further calls as it sees fit upon the issuance of a series of preferred stock.
There are currently no provisions discriminating against any existing or
prospective holder of Preferred Stock based on such shareholder owning a
substantial amount of stock.
CHANGING RIGHTS OF STOCK
Under the Canada Business Corporations Act, the rights of holders of stock may
be changed by special resolution amending the Articles of Continuation. A
shareholder or Director entitled to vote at a shareholder meeting may propose
such a resolution. Notice of the meeting where such amendment will be considered
must set out the proposed amendment. In considering such an amendment, the
holders of the class or classes subject to modification under the proposed
amendment are entitled to vote separately as a class on the amendment regardless
or whether the shares are generally entitled to vote. The rights of holders of
common shares may not be modified other than by a vote of the majority of the
common shares voting on such modification. Because a quorum for a general
meeting of shareholders can exist with one shareholder (proxy holder) personally
present, the rights of holders of common shares may be modified by less than a
majority of our issued common shares. None of these conditions are more
stringent than required by law.
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SHAREHOLDER MEETINGS
ANNUAL MEETINGS - TIME AND PLACE
The Chairman of the Board, managing Director, or President is authorized to set
the time, date, and place of the annual meeting. Such meeting may be held
anywhere within Canada or the United States.
NOTICE OF MEETINGS
Notice of the time and place of each meeting of the shareholders shall be sent
between fifty (50) and twenty-one (21) days before the meeting to each
shareholder entitled to vote, each Director, and to the auditors of the Company.
RECORD DATE
The Board may set the record date for a meeting between fifty (50) and
twenty-one (21) days before the meeting. If no record date is set, the record
date shall be the close of business on the date immediately preceding the day on
which the notice is given, or if no notice is given, the day on which the
meeting is held.
RIGHT TO VOTE
Before each meeting, the Company shall prepare a list of shareholders entitled
to vote at the meeting. If a record date is fixed for the meeting, the list
shall consist of those registered at the close of business on the day of record.
If no record date is fixed, the shareholders listed shall be those listed at the
close of business on the last business day immediately preceding the day on
which notice of a meeting is given, or if no notice is given, the day on which
the meeting is held. Only those shareholders entitled to vote are entitled to be
present at the meeting.
MEETINGS WITHOUT NOTICE
A meeting may be held without notice at any time and place permitted by the
Canada Business Corporations Act if: (1) all shareholders entitled to vote are
present in person or represented by proxy or if not present or represented by
proxy, that shareholder has waived notice or otherwise consented to the meeting,
and (2) if the auditors and Directors are present or waive notice of or
otherwise consent to such meeting being held.
OTHER PROVISIONS
There are no limitations on the rights to own our common shares, including the
rights of non-resident or foreign shareholders to hold or exercise voting rights
on our shares. Neither our articles of association nor bylaws contain any
provision that would have an effect of delaying, deferring, or preventing a
change in control of the Company and that would operate only with respect to a
merger, acquisition, or corporate restructuring involving us or any of our
subsidiaries. Our bylaws do not contain any provisions governing the ownership
threshold above which shareholder ownership must be disclosed.
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MATERIAL CONTRACTS
The following are the material contracts related to our business:
Asset Purchase Agreement between Integrated Retail Corp. and Softech 002 Limited
Partnership dated September 29th, 1999.
Employment Agreement with Ayaz Kara dated June 1, 1999. See "Item 6 - Directors,
Senior Management and Employees - Compensation - Executive Officers - Employment
Contracts" for a description of this agreement.
Services Agreement with TMH Holdings Ltd. dated effective April 1, 2001. See
"Item 6 - Directors, Senior Management and Employees - Compensation - Executive
Officers - Employment Contracts" for a description of this agreement.
Services Agreement with Summit Capital Corporation dated effective April 1,
2001. See "Item 6 - Directors, Senior Management and Employees - Compensation -
Executive Officers - Employment Contracts" for a description of this agreement.
Asset Purchase Agreement between M & K Video Spot Inc. and Video Headquarters
Inc. dated July 11, 2000. See "Item 4 - Information on the Company - Our
Acquisition of M & K Video Spot" for a description of the agreement.
Management and Revenue Sharing Agreement dated September 29, 1999 between the
Company and Video Limited Partnership. See "Item 5 - Operating and Financial
Review and Prospects - Year Ended May 31, 2001 Compared to Year Ended May 31,
2000 - Video Limited Partnership Disbursements" for a description of the
Agreement.
Memorandum of Agreement between Raeco Holdings Incorporated ("Raeco") and the
Company's subsidiary, Star Vision Enterprises Inc. ("Star Vision"), regarding
the sale of Raeco's assets to Star Vision dated June 15, 2000.
Asset Purchase Agreement with Hollywood North Video Ltd. dated effective March
15, 2001. See Item 4 - "Information on the Company - Our Acquisitions - Our
Acquisition of Hollywood North Video Ltd." for a description of this Agreement.
Composite Convertible Subordinated Debenture dated December 1, 2001.
Share Sale Agreement dated effective December 26, 2001 with The Game Holdings,
Ltd. See "Item 4 - Information on the Company - E-Trend Networks, Inc."
Promissory Note granted by The Game Holdings, Ltd. dated December 26, 2001. See
"Item 4 - Information on the Company - E-Trend Networks, Inc."
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Form of Amended Definitive Share Purchase Agreement dated effective February 1,
2002 with The Game Holdings, Ltd. See "Item 4 - Information on the Company -
E-Trend Networks, Inc."
Form of Amended Promissory Note granted by The Game Holdings, Ltd. dated
February 1, 2002. See "Item 4 - Information on the Company - E-Trend Networks,
Inc.".
Lease with G&J Holdings Inc. See "Item 4. Information on the Company - Our
Properties and Equipment" and "Item 7. Majority Shareholders and Related Party
Transactions - Related Party Transactions."
Line of Credit and Credit Facility with Community Savings. See "Item 5.
Operating and Financial Review and Prospects - Year Ended May 31, 2001 Compared
to Year Ended May 31, 2000 - Cash From Financing Activities."
EXCHANGE CONTROLS
Canada has no system of exchange controls. There are no exchange restrictions on
borrowing from foreign countries or on the remittance of dividends, interest,
royalties and similar payments, management fees, loan repayments, settlement of
trade debts, or the repatriation of capital. However, any dividends remitted to
U.S. Holders, as defined below, will be subject to withholding tax. See the
heading "Taxation" below.
There are no limitations under the laws of Canada or Alberta or in our
memorandum and articles on the rights of non-Canadians to hold or vote our
common shares. Under the provisions of the Investment Canada Act (the "ICA" or
the "Act"), as amended by the Canada-United States Free Trade Implementation Act
(Canada), and the Canada-United States Free Trade Agreement, review and approval
of the transaction by the Investment Canada Agency ("Investment Canada"), the
federal agency created by the ICA are required where a U.S. person directly
acquires control of a Canadian business with assets of more than $209 million
(2001). The term "control" is defined as any one or more non-Canadian persons
acquiring all or substantially all of the assets used in the Canadian business,
or the acquisition of the voting shares of a Canadian corporation carrying on
the Canadian business or the acquisition of the voting interest of an entity
controlling or carrying on the Canadian business. The acquisition of the
majority of the outstanding shares is deemed to be an "acquisition of control"
of a corporation unless it can be established that the purchaser will not, in
fact, control the Canadian corporation.
Subject to the comments contained in the following paragraph regarding WTO
investors, investments requiring notification and review are all direct
acquisitions of Canadian businesses with assets of $5,000,000 or more and all
indirect acquisitions of Canadian businesses with assets between $5,000,000 and
$50,000,000 which represent more than 50% of the value of the total
international transaction. (Indirect acquisition means the acquisition of the
voting rights of an entity controlling the Canadian corporation.) In addition,
specific acquisitions or new businesses in designated types of business
activities related to Canada's cultural heritage or national identity, which
would normally only be notifiable, could be reviewed if the Government of Canada
considers it in the public interest to do so.
The ICA was amended with the implementation of the agreement establishing the
World Trade Organization ("WTO") to provide for special review thresholds for
"WTO investors", as defined in the Act. "WTO investor" generally means (i) an
individual, other than a Canadian, who is a national of a
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WTO member (such as, for example, the United States), or who has the right of
permanent residence in relation to that WTO member, (ii) governments of WTO
members, and (iii) entities that are not Canadian controlled, but which are WTO
investor controlled, as determined by rules specified in the Act. The special
review thresholds for WTO investors do not apply, and the general rules
described above do apply, to the acquisition of control of certain types of
businesses specified in the Act, including a business that is a "cultural
business". If the WTO Investor rules apply, an investment in shares of the
Issuer by or from a WTO investor will be reviewable only if it is an investment
to acquire control of the Issuer and the value of the assets of the Issuer is
equal to or greater than a specified amount (the "WTO Review Threshold"). The
WTO Review Threshold is adjusted annually by a formula relating to increases in
the nominal gross domestic product of Canada. The WTO Review Threshold was
$209,000,000 (in 2001).
If any non-Canadian, whether or not a WTO Investor, acquires control of the
Issuer by the acquisition of shares, but the transaction is not reviewable as
described above, the non-Canadian is required to notify the Canadian government
and to provide certain basic information relating to the investment. A
non-Canadian, whether or not a WTO investor, is also required to provide a
notice to the government on the establishment of a new Canadian business. If the
business of the Issuer is a prescribed type of business activity relating to
Canada's cultural heritage or national identity, and if the Canadian government
considers it to be in the public interest to do so, then the Canadian government
may give a notice in writing within 21 days requiring the investment be
reviewed.
For non-Canadians (other than WTO investors), an indirect acquisition of
control, by the acquisition of voting interests of an entity that directly or
indirectly controls the Issuer, is reviewable if the value of the assets of the
Issuer is then $50,000,000 or more. If the WTO investor rules apply, then this
requirement does not apply to a WTO investor, or to a person acquiring the
entity from a WTO investor. Special rules specified in the Act apply if the
value of the assets of the Issuer is more than 50% of the value of the entity so
acquired. By these special rules, if the non-Canadian (whether or not a WTO
investor) is acquiring control of an entity that directly or indirectly controls
the Issuer, and the value of the assets of the Issuer and all other entities
carrying on business in Canada, calculated in the manner provided in the Act and
the regulations under the Act, is more than 50% of the value, calculated in the
manner provided in the Act and the regulations under the Act, of the assets of
all entities, the control of which is acquired, directly or indirectly, in the
transaction of which the acquisition of control of the Issuer forms a part, then
the thresholds for a direct acquisition of control as discussed above will
apply. That is, a WTO Review threshold of $209 million (in 2001) for a WTO
investor or a threshold of $5,000,000 for a non-Canadian other than a WTO
investor. If the value exceeds that level, then the transaction must be reviewed
in the same manner as a direct acquisition of control by the purchase of shares
of the Issuer.
If an investment is reviewable, an application for review in the form prescribed
by regulations is normally required to be filed with the agency established by
the Act (the "Agency") prior to the investment and the investment may not be
consummated until the review has been completed. There are, however, certain
exceptions. Applications concerning indirect acquisitions may be filed up to 30
days after the investment is consummated and applications concerning reviewable
investments in culture-sensitive sectors are required upon receipt of a notice
for review. There is, moreover, provision for the Minister (a person designated
as such under the Act) to permit an investment to be consummated prior to
completion of review, if he is satisfied that delay would cause undue hardship
to the acquirer or jeopardize the operation of the Canadian business that is
being acquired. The Agency will submit the application to the Minister, together
with any other information or written undertakings given by the
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acquirer and any representation submitted to the Agency by a province that is
likely to be significantly affected by the investment.
The Minister will then determine whether the investment is likely to be of net
benefit to Canada, taking into account the information provided and having
regard for other factors where they are relevant. Some of the factors to be
considered are the effect of the investment on the level and nature of economic
activity in Canada, including the effect on employment, on resource processing,
on the utilization of parts, components and services produced in Canada, and on
exports from Canada.
Additional factors of assessment include (i) the degree and significance of
participation by Canadians in the Canadian business and in any industry in
Canada of which it forms a part; (ii) the effect of the investment on
productivity, industrial efficiency, technological development, product
innovation and product variety in Canada; (iii) the effect of the investment on
competition within any industry or industries in Canada; (iv) the compatibility
of the investment with national industrial, economic and cultural policies
taking into consideration industrial, economic and cultural objectives
enunciated by the government or legislature of any province likely to be
significantly affected by the investment; and (v) the contribution of the
investment to Canada's ability to compete in world markets.
To insure prompt review and decision, the Act sets certain time limits for the
Agency and the Minister. Within 45 days after a completed application has been
received, the Minister must notify the acquirer that (a) he is satisfied that
the investment is likely to be of net benefit to Canada, or (b) he is unable to
complete his review, in which case he shall have 30 additional days to complete
his review (unless the acquirer agrees to a longer period), or (c) he is not
satisfied that the investment is likely to be of net benefit to Canada.
Where the Minister has advised the acquirer that he is not satisfied that the
investment is likely to be of net benefit to Canada, the acquirer has the right
to make representations and submit undertakings within 30 days of the date of
the notice (or any further period that is agreed upon between the acquirer and
the Minister). On the expiration of the 30-day period (or the agreed extension),
the Minister must quickly notify the acquirer (a) that he is now satisfied that
the investment is likely to be of net benefit to Canada or (b) confirming that
he is not satisfied that the investment is likely to be of net benefit to
Canada. In the latter case, the acquirer may not proceed with the investment or,
if the investment has already been consummated, must relinquish control of the
Canadian business. The Act authorizes the Minister to give written opinions,
binding the Minister, on the application of the Act or regulations to the
persons seeking the opinions to the Agency or a designated official. The Act
also authorizes the Minister to issue guidelines and interpretations with
respect to the application and administration of any provision of the Act or the
regulations.
The Act provides for civil penalties for non-compliance with any provision
except breach of confidentiality or provision of false information, for which
there are criminal penalties.
TAXATION
UNITED STATES FEDERAL INCOME TAX CONSEQUENCES
The following is a discussion of certain possible United States federal income
tax consequences, under current law, applicable to a U.S. Holder (as hereinafter
defined) of common shares of the Company. This discussion does not address
consequences peculiar to persons subject to special provisions of
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federal income tax law, such as those described below as excluded from the
definition of a U.S. Holder. In addition, this discussion does not cover any
state, local or foreign tax consequences. See "Canadian Federal Income Tax
Consequences" below.
The following discussion is based upon the sections of the Internal Revenue Code
of 1986, as amended (the "Code"), Treasury Regulations, published Internal
Revenue Service ("IRS") rulings, published administrative positions of the IRS
and court decisions that are currently applicable, any or all of which could be
materially and adversely changed, possibly on a retroactive basis, at any time
and which are subject to differing interpretations. This discussion does not
consider the potential effects, both adverse and beneficial, of any proposed
legislation which, if enacted, could be applied, possibly on a retroactive
basis, at any time. Holders and prospective holders of common shares of the
Company should consult their own tax advisors about the state, local, and
foreign tax consequences of purchasing, owning and disposing of common shares of
the Company.
U.S. HOLDERS
As used herein, a "U.S. Holder" means a holder of common shares of the Company
who is (i) a citizen or individual resident of the United States, (ii) a
corporation or partnership created or organized in or under the laws of the
United States or of any political subdivision thereof, (iii) an estate whose
income is taxable in the United States irrespective of source or (iv) a trust
subject to the primary supervision of a court within the United States and
control of a United States fiduciary as described Section 7701(a)(30) of the
Code. This summary does not address the tax consequences to, and U.S. Holder
does not include, persons subject to specific provisions of federal income tax
law, such as tax-exempt organizations, qualified retirement plans, individual
retirement accounts and other tax-deferred accounts, financial institutions,
insurance companies, real estate investment trusts, regulated investment
companies, broker-dealers, persons or entities that have a "functional currency"
other than the U.S. dollar, shareholders subject to the alternative minimum tax,
shareholders who hold common shares as part of a straddle, hedging, conversion
transaction, constructive sale or other arrangement involving more than one
position, and shareholders who acquired their common shares through the exercise
of employee stock options or otherwise as compensation for services. This
summary is limited to U.S. Holders who own common shares as capital assets
within the meaning of Section 1221 of the Code. This summary does not address
the consequences to a person or entity holding an interest in a shareholder or
the consequences to a person of the ownership, exercise or disposition of any
options, warrants or other rights to acquire common shares.
DISTRIBUTION ON COMMON SHARES OF THE COMPANY
U.S. Holders receiving dividend distributions (including constructive dividends)
with respect to common shares of the Company are required to include in gross
income for United States federal income tax purposes the gross amount of such
distributions, equal to the U.S. dollar value of such distributions on the date
of receipt (based on the exchange rate on such date), to the extent that the
Company has current or accumulated earnings and profits, without reduction for
any Canadian income tax withheld from such distributions. Such Canadian tax
withheld may be credited, subject to certain limitations, against the U.S.
Holder's federal income tax liability or, alternatively, may be deducted in
computing the U.S. Holder's federal taxable income by those who itemize
deductions. (See more detailed discussion at "Foreign Tax Credit" below). To the
extent that distributions exceed current or accumulated earnings and profits of
the Company, they will be treated first as a return of capital up to the U.S.
Holder's adjusted basis in the common shares and thereafter as gain from the
sale or exchange of the common
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shares. Preferential tax rates for long-term capital gains are applicable to a
U.S. Holder which is an individual, estate or trust. There are currently no
preferential tax rates for long-term capital gains for a U.S. Holder which is a
corporation.
In the case of foreign currency received as a dividend that is not converted by
the recipient into U.S. dollars on the date of receipt, a U.S. Holder will have
a tax basis in the foreign currency equal to its U.S. dollar value on the date
of receipt. Generally any gain or loss recognized upon a subsequent sale or
other disposition of the foreign currency, including the exchange for U.S.
dollars, will be ordinary income or loss. However, an individual whose realized
gain does not exceed $200 will not recognize that gain, to the extent that there
are no expenses associated with the transaction that meet the requirements for
deductibility as a trade or business expense (other than travel expenses in
connection with a business trip) or as an expense for the production of income.
Dividends paid on the common shares of the Company generally will not be
eligible for the dividends received deduction provided to corporations receiving
dividends from certain United States corporations. A U.S. Holder which is a
corporation and which owns shares representing at least 10% of the voting power
and value of the Company may, under certain circumstances, be entitled to a 70%
(or 80% if the U.S. Holder owns shares representing at least 20% of the voting
power and value of the Company) deduction of the United States source portion of
dividends received from the Company (unless the Company qualifies as a "foreign
personal holding company" or a "passive foreign investment company," as defined
below). The availability of this deduction is subject to several complex
limitations which are beyond the scope of this discussion.
Certain information reporting and backup withholding rules may apply with
respect to the Company's common shares. In particular, a payor or middleman
within the U.S. will be required to withhold 31% of any payments to a holder of
the Company's common shares of dividends on, or proceeds from the sale of, such
common shares within the U.S., unless the holder is an exempt recipient, if the
holder fails to furnish its correct taxpayer identification number or otherwise
fails to comply with, or establish an exemption from, the backup withholding tax
requirements. Any amounts withheld under the U.S. backup withholding tax rules
will be allowed as a refund or a credit against the U.S. Holder's U.S. federal
income tax liability, provided the required information is furnished to the IRS.
U.S. Holders are urged to consult their own tax counsel regarding the
information reporting and backup withholding rules applicable to the Company's
common shares.
FOREIGN TAX CREDIT
A U.S. Holder who pays (or has withheld from distributions) Canadian income tax
with respect to the ownership of common shares of the Company may be entitled,
at the option of the U.S. Holder, to either receive a deduction or a tax credit
for such foreign tax paid or withheld. Generally, it will be more advantageous
to claim a credit because a credit reduces United States federal income taxes on
a dollar-for-dollar basis, while a deduction merely reduces the taxpayer's
income subject to tax. This election is made on a year-by-year basis and applies
to all foreign taxes paid by (or withheld from) the U.S. Holder during that
year. There are significant and complex limitations which apply to the credit,
among which is the general limitation that the credit cannot exceed the
proportionate share of the U.S. Holder's United States income tax liability that
the U.S. Holder's foreign source income bears to his or its worldwide taxable
income. In the determination of the application of this limitation, the various
items of income and deduction must be classified into foreign and domestic
sources. Complex rules govern this classification process. In addition, this
limitation is calculated separately with respect to specific classes
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of income such as "passive income, " "high withholding tax interest," "financial
services income," "shipping income," and certain other classifications of
income. Dividends distributed by the Company will generally constitute "passive
income" or, in the case of certain U.S. Holders, "financial services income" for
these purposes. In addition, U.S. Holders which are corporations that own 10% or
more of the voting stock of the Company may be entitled to an "indirect" foreign
tax credit under Section 902 with respect to the payment of dividends by the
Company under certain circumstances and subject to complex rules and
limitations. The availability of the foreign tax credit and the application of
the limitations on the credit are fact specific, and U.S. Holders of common
shares of the Company should consult their own tax advisors regarding their
particular circumstances.
DISPOSITION OF COMMON SHARES OF THE COMPANY
A U.S. Holder will recognize gain or loss upon the sale of common shares of the
Company equal to the difference, if any, between (i) the amount of cash plus the
fair market value of any property received, and (ii) the shareholder's tax basis
in the common shares of the Company. Preferential tax rates apply to long-term
capital gains of U.S. Holders which are individuals, estates or trusts. This
gain or loss will be capital gain or loss if the common shares are a capital
asset in the hands of the U.S. Holder, which will be long-term capital gain or
loss if the common shares of the Company are held for more than one year.
Deductions for net capital losses are subject to significant limitations. For
U.S. Holders which are not corporations, any unused portion of such net capital
loss may be carried over to be used in later tax years until such net capital
loss is thereby exhausted. For U.S. Holders that are corporations (other than
corporations subject to Subchapter S of the Code), an unused net capital loss
may be carried back three years and carried forward five years from the loss
year to be offset against capital gains until such net capital loss is thereby
exhausted.
OTHER CONSIDERATIONS
In the following circumstances, the above sections of this discussion may not
describe the United States federal income tax consequences resulting from the
holding and disposition of common shares:
FOREIGN PERSONAL HOLDING COMPANY
If at any time during a taxable year (i) more than 50% of the total combined
voting power or the total value of the Company's outstanding shares is owned,
directly or indirectly, by five or fewer individuals who are citizens or
residents of the United States and (ii) 60% (50% in some circumstances) or more
of the Company's gross income for such year was "foreign personal holding
company income" (e.g. dividends, interest and similar income), the Company may
be treated as a "foreign personal holding company." In that event, U.S. Holders
that hold common shares would be required to include in gross income for such
year their allocable portions of such "foreign personal holding company income"
to the extent the Company does not actually distribute such income. The Company
does not believe that it currently qualifies as a foreign personal holding
company. However, there can be no assurance that the Company will not be
considered a foreign personal holding company for the current or any future
taxable year.
FOREIGN INVESTMENT COMPANY
If 50% or more of the combined voting power or total value of the Company's
outstanding shares is held, directly or indirectly, by citizens or residents of
the United States, United States domestic partnerships or
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corporations, or estates or trusts other than foreign estates or trusts (as
defined by the Code Section 7701(a)(31)), and the Company is found to be engaged
primarily in the business of investing, reinvesting, or trading in securities,
commodities, or any interest therein, it is possible that the Company may be
treated as a "foreign investment company" as defined in Section 1246 of the
Code, causing all or part of any gain realized by a U.S. Holder selling or
exchanging common shares to be treated as ordinary income rather than capital
gain. The Company does not believe that it currently qualifies as a foreign
investment company. However, there can be no assurance that the Company will not
be considered a foreign investment company for the current or any future taxable
year.
PASSIVE FOREIGN INVESTMENT COMPANY
Certain United States income tax legislation contains rules governing "passive
foreign investment companies" ("PFIC") which can have significant tax effects on
U.S. Holders of foreign corporations. These rules do not apply to non-U.S.
Holders. Section 1297 of the Code defines a PFIC as a corporation that is not
formed in the United States and, for any taxable year, either (i) 75% or more of
its gross income is "passive income," which includes interest, dividends and
certain rents and royalties or (ii) the average percentage, by fair market value
(or, if the corporation is not publicly traded and either is a controlled
foreign corporation or makes an election, by adjusted tax basis), of its assets
that produce or are held for the production of "passive income" is 50% or more.
If a foreign corporation owns, directly or indirectly, at least 25% by value of
the stock a second corporation, then for purposes of the PFIC tests described
above, the first corporation will be treated as owning a proportionate share of
the assets of, and as receiving a proportionate share of the income of, the
second corporation. The Company believes that it did not qualify as a PFIC for
the fiscal year ended May 31, 2002. There can be no assurance that the Company's
determination concerning its PFIC status will not be challenged or that it will
be able to satisfy record keeping requirements that will be imposed on a
qualified electing fund ("QEF"). Each U.S. Holder of the Company is urged to
consult a tax advisor with respect to how the PFIC rules affect their tax
situation.
A U.S. Holder who holds stock in a foreign corporation during any year in which
such corporation qualifies as a PFIC is subject to United States federal income
taxation under one of two alternative tax regimes at the election of each such
U.S. Holder. The following is a discussion of such two alternative tax regimes
applied to such U.S. Holders of the Company in the event the Company were
determined to be a PFIC. In addition, special rules apply if a foreign
corporation qualifies as both a PFIC and a "controlled foreign corporation" (as
defined below) and a U.S. Holder owns, actually or constructively, 10% or more
of the total combined voting power of all classes of stock entitled to vote of
such foreign corporation (See more detailed discussion at "Controlled Foreign
Corporation" below).
A U.S. Holder who elects in a timely manner to treat the Company as a QEF (an
"Electing U.S. Holder") will be subject, under Section 1293 of the Code, to
current federal income tax for any taxable year in which the Company qualifies
as a PFIC on his pro rata share of the Company's (i) "net capital gain" (the
excess of net long-term capital gain over net short-term capital loss), which
will be taxed as long-term capital gain to the Electing U.S. Holder and (ii)
"ordinary earnings" (the excess of earnings and profits over net capital gain),
which will be taxed as ordinary income to the Electing U.S. Holder, in each
case, for the shareholder's taxable year in which (or with which) the Company's
taxable year ends, regardless of whether such amounts are actually distributed.
The effective QEF election also allows the Electing U.S. Holder to (i) generally
treat any gain realized on the disposition of his Company common shares (or
deemed to be realized on the pledge of his shares) as
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capital gain; (ii) treat his share of the Company's net capital gain, if any, as
long-term capital gain instead of ordinary income; and (iii) either avoid
interest charges resulting from PFIC status altogether, or make an annual
election, subject to certain limitations, to defer payment of current taxes on
his share of the Company's annual realized net capital gain and ordinary
earnings subject, however, to an interest charge. If the Electing U.S. Holder is
not a corporation, such an interest charge would be treated as "personal
interest" that is not deductible.
The procedure a U.S. Holder must comply with in making an effective QEF election
will depend on whether the year of the election is the first year in the U.S.
Holder's holding period in which the Company is a PFIC. If the U.S. Holder makes
a QEF election in such first year, i.e., a timely QEF election, then the U.S.
Holder may make the QEF election by simply filing the appropriate documents at
the time the U.S. Holder files his tax return for such first year. If, however,
the Company qualified as a PFIC in a prior year, then in addition to filing
documents, the U.S. Holder must elect to recognize (i) under the rules of
Section 1291 of the Code (discussed herein), any gain that he would otherwise
recognize if the U.S. Holder sold his stock on the qualification date or (ii) if
the Company is a controlled foreign corporation, the U.S. Holder's pro rata
share of the Company's post-1986 earnings and profits as of the qualification
date. The qualification date is the first day of the Company's first tax year in
which the Company qualified as a QEF with respect to such U.S. Holder. The
elections to recognize such gain or earnings and profits can only be made if
such U.S. Holder's holding period for the common shares of the Company includes
the qualification date. By electing to recognize such gain or earnings and
profits, the U.S. Holder will be deemed to have made a timely QEF election. A
U.S. Holder who made elections to recognize gain or earnings and profits after
May 1, 1992 and before January 27, 1997 may, under certain circumstances, elect
to change such U.S. Holder's qualification date to the first day of the first
QEF year. U.S. Holders are urged to consult a tax advisor regarding the
availability of and procedure for electing to recognize gain or earnings and
profits under the foregoing rules.
A QEF election, once made with respect to the Company, applies to the tax year
for which it was made and to all subsequent tax years, unless the election is
invalidated or terminated, or the IRS consents to revocation of the election. If
a QEF election is made by a U.S. Holder and the Company ceases to qualify as a
PFIC in a subsequent tax year, the QEF election will remain in effect, although
not applicable, during those tax years in which the Company does not qualify as
a PFIC. Therefore, if the Company again qualifies as a PFIC in a subsequent tax
year, the QEF election will be effective and the U.S. Holder will be subject to
the rules described above for Electing U.S. Holders in such tax year and any
subsequent tax years in which the Company qualifies as a PFIC. In addition, the
QEF election remains in effect, although not applicable, with respect to an
Electing U.S. Holder even after such U.S. Holder disposes of all of his or its
direct and indirect interest in the shares of the Company. Therefore, if such
U.S. Holder reacquires an interest in the Company, that U.S. Holder will be
subject to the rules described above for Electing U.S. Holders for each tax year
in which the Company qualifies as a PFIC.
If a U.S. Holder does not make a timely QEF election during a year in which it
holds (or is deemed to have held) the common shares in question and the Company
is a PFIC (a "Non-Electing U.S. Holder"), then special taxation rules under
Section 1291 of the Code will apply to (i) gains realized on the disposition (or
deemed to be realized by reasons of a pledge) of his Company common shares and
(ii) certain "excess distributions" (generally, distributions received in the
current taxable year that are in excess of 125% of the average distributions
received during the three preceding years or, if shorter, the U.S. Holder's
holding period) by the Company.
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A Non-Electing U.S. Holder generally would be required to pro rate all gains
realized on the disposition of his Company common shares and all excess
distributions on his Company common shares over the entire holding period for
the common shares. All gains or excess distributions allocated to prior years of
the U.S. Holder (other than years prior to the first taxable year of the Company
during such U.S. Holder's holding period and beginning after January 1, 1987 for
which it was a PFIC) would be taxed at the highest tax rate for each such prior
year applicable to ordinary income. The Non-Electing U.S. Holder also would be
liable for interest on the foregoing tax liability for each such prior year
calculated as if such liability had been due with respect to each such prior
year. A Non-Electing U.S. Holder that is not a corporation must treat this
interest charge as "personal interest" which, as discussed above, is
nondeductible. The balance of the gain or the excess distribution will be
treated as ordinary income in the year of the disposition or distribution, and
no interest charge will be incurred with respect to such balance.
If the Company is a PFIC for any taxable year during which a Non-Electing U.S.
Holder holds Company common shares, then the Company will continue to be treated
as a PFIC with respect to such Company common shares, even if it is no longer
definitionally a PFIC. A Non-Electing U.S. Holder may terminate this deemed PFIC
status by electing to recognize gain (which will be taxed under the rules
discussed above for Non-Electing U.S. Holders) as if such Company common shares
had been sold on the last day of the last taxable year for which it was a PFIC.
Effective for tax years of U.S. Holders beginning after December 31, 1997, U.S.
Holders who hold, actually or constructively, marketable stock (as specifically
defined in the Treasury Regulations) of a foreign corporation that qualifies as
a PFIC may annually elect to mark such stock to the market (a "mark-to-market
election"). If such an election is made, such U.S. Holder will generally not be
subject to the special taxation rules of Section 1291 discussed above. However,
if the mark-to-market election is made by a Non-Electing U.S. Holder after the
beginning of the holding period for the PFIC stock, then the Section 1291 rules
will apply to certain dispositions of, distributions on and other amounts
taxable with respect to the Company common shares. A U.S. Holder who makes the
mark-to-market election will include in income for the taxable year for which
the election was made an amount equal to the excess, if any, of the fair market
value of the common shares of the Company as of the close of such tax year over
such U.S. Holder's adjusted basis in such common shares. In addition, the U.S.
Holder is allowed a deduction for the lesser of (i) the excess, if any, of such
U.S. Holder's adjusted tax basis in the common shares over the fair market value
of such shares as of the close of the tax year, or (ii) the excess, if any, of
(A) the mark-to-market gains for the common shares in the Company included by
such U.S. Holder for prior tax years, including any amount which would have been
included for any prior tax year but for the Section 1291 interest on tax
deferral rules discussed above with respect to Non-Electing U.S. Holders, over
(B) the mark-to-market losses for shares that were allowed as deductions for
prior tax years. A U.S. Holder's adjusted tax basis in the common shares of the
Company will be adjusted to reflect the amount included in or deducted from
income as a result of a mark-to-market election. A mark-to-market election
applies to the taxable year in which the election is made and to each subsequent
taxable year, unless the Company common shares cease to be marketable, as
specifically defined, or the IRS consents to revocation of the election. Because
the IRS has not established procedures for making a mark-to-market election,
U.S. Holders should consult their tax advisor regarding the manner of making
such an election.
Under Section 1291(f) of the Code, the IRS has issued Proposed Treasury
Regulations that, subject to certain exceptions, would treat as taxable certain
transfers of PFIC stock by Non-Electing U.S. Holders that are generally not
otherwise taxed, such as gifts, exchanges pursuant to corporate reorganizations,
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and transfers at death. Generally, in such cases the basis of the Company common
shares in the hands of the transferee and the basis of any property received in
the exchange for those common shares would be increased by the amount of gain
recognized. Under the Proposed Treasury Regulations, an Electing U.S. Holder
would not be taxed on certain transfers of PFIC stock, such as gifts, exchanges
pursuant to corporate reorganizations, and transfers at death. The transferee's
basis in this case will depend on the manner of the transfer. The specific tax
effect to the U.S. Holder and the transferee may vary based on the manner in
which the common shares are transferred. Each U.S. Holder of the Company is
urged to consult a tax advisor with respect to how the PFIC rules affect their
tax situation.
Certain special, generally adverse, rules will apply with respect to Company
common shares while the Company is a PFIC whether or not it is treated as a QEF.
For example under Section 1298(b)(6) of the Code, a U.S. Holder who uses PFIC
stock as security for a loan (including a margin loan) will, except as may be
provided in regulations, be treated as having made a taxable disposition of such
shares.
CONTROLLED FOREIGN CORPORATION
If more than 50% of the total combined voting power of all classes of shares
entitled to vote or the total value of the shares of the Company is owned,
actually or constructively, by citizens or residents of the United States,
United States domestic partnerships or corporations, or estates or trusts other
than foreign estates or trusts (as defined by the Code Section 7701(a)(31)),
each of which own, actually or constructively, 10% or more of the total combined
voting power of all classes of shares entitled to vote of the Company ("United
States Shareholder"), the Company could be treated as a controlled foreign
corporation ("CFC") under Subpart F of the Code. This classification would
affect many complex results, one of which is the inclusion of certain income of
a CFC which is subject to current U.S. tax. The United States generally taxes
United States Shareholders of a CFC currently on their pro rata shares of the
Subpart F income of the CFC. Such United States Shareholders are generally
treated as having received a current distribution out of the CFC's Subpart F
income and are also subject to current U.S. tax on their pro rata shares of the
CFC's earnings invested in U.S. property. The foreign tax credit described above
may reduce the U.S. tax on these amounts. In addition, under Section 1248 of the
Code, gain from the sale or exchange of shares by a U.S. Holder of common shares
of the Company which is or was a United States Shareholder at any time during
the five-year period ending with the sale or exchange is treated as ordinary
income to the extent of earnings and profits of the Company attributable to the
shares sold or exchanged. If a foreign corporation is both a PFIC and a CFC, the
foreign corporation generally will not be treated as a PFIC with respect to
United States Shareholders of the CFC. This rule generally will be effective for
taxable years of United States Shareholders beginning after 1997 and for taxable
years of foreign corporations ending with or within such taxable years of United
States Shareholders. Special rules apply to United States Shareholders who are
subject to the special taxation rules under Section 1291 discussed above with
respect to a PFIC. Because of the complexity of Subpart F, a more detailed
review of these rules is outside of the scope of this discussion. The Company
does not believe that it currently qualifies as a CFC. However, there can be no
assurance that the Company will not be considered a CFC for the current or any
future taxable year.
CANADIAN FEDERAL INCOME TAX CONSIDERATIONS
In this section, we summarize the material anticipated Canadian federal income
tax considerations relevant to your purchase of shares.
87
<page>
Under the Income Tax Act, as modified by the Canada-United States Income Tax
Convention, if you are an Unconnected U.S. Shareholder you will generally be
exempt from Canadian tax on a capital gain realized on an actual or deemed
disposition of the shares (including a deemed disposition on death).
Dividends paid, credited or deemed to have been paid or credited on the shares
to Unconnected U.S. Shareholders will be subject to a Canadian withholding tax.
Under the Canada-United States Income Tax Convention, the rate of withholding
tax generally applicable to Unconnected U.S. Shareholders who beneficially own
the dividends is reduced to 15%. In the case of Unconnected U.S. Shareholders
that are companies that beneficially own at least 10% of our voting shares, the
rate of withholding tax on dividends is reduced to 5%.
DIVIDENDS AND PAYING AGENTS
None.
DOCUMENTS ON DISPLAY
The documents incorporated as exhibits to this annual report are available for
inspection at our principle business office located at 6201 - 46th Avenue, Red
Deer, Alberta T4N 6Z1, or at our records office located at 1900, 715 - 5th
Avenue S.W., Calgary, Alberta, T2P 2X6.
ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS
Not Applicable.
ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES
NOT APPLICABLE.
PART II
ITEM 13 DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES
Not applicable.
ITEM 14 MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF
PROCEEDS
Not applicable.
88
<page>
ITEM 15 CONTROLS AND PROCEDURES
Within the 90-day period prior to the filing of this report there have been no
significant changes in the Company's internal controls or the occurrence of
events or other factors that could significantly affect these controls.
ITEM 16 [RESERVED]
Not applicable.
PART III
ITEM 17. FINANCIAL STATEMENTS
See pages beginning with Page F-1.
ITEM 18. FINANCIAL STATEMENTS
Not applicable.
ITEM 19. EXHIBITS
Exhibit
Number Description
- --------------------------------------------------------------------------------
1.1 Certificate of Incorporation dated September 5, 1997.(1)
1.2 Certificate of Amendment dated December 22, 1997.(1)
1.3 Certificate of Amendment and Registration of Restated Articles
dated September 18, 1998.(1)
1.4 Certificate of Amendment and Registration of Restated Articles
dated November 25, 1999.(1)
1.5 Certificate of Continuance dated December 1, 2000.(1)
1.6 Articles of Continuance dated December 4, 2000.(1)
89
<page>
Exhibit
Number Description
- --------------------------------------------------------------------------------
1.7 General By-Laws dated December 11, 1997. (1)
2.1 Composite Convertible Subordinated Debenture dated December 1,
2001.
4.1 Management and Revenue Sharing Agreement dated September 29, 1999
between the Company and Video Limited Partnership. (1)
4.2 Employment Agreement with Ayaz Kara dated June 1, 1999.(1)
4.3 Promissory Note issued to Rentrak Corp. dated July 19, 1999.(1)
4.4 Asset Purchase Agreement between M & K Video Spot Inc. and Video
Headquarters Inc. dated July 11, 2000.(1)
4.5 Memorandum of Agreement between Raeco Holdings Incorporated and
the Company's subsidiary, Star Vision Enterprises Inc. dated June
15, 2000.(1)
4.6 Asset Sale Agreement between Hollywood North Video Ltd. and VHQ
Entertainment Inc. dated effective March 15, 2001.(1)
4.7 Definitive Share Purchase Agreement between VHQ Entertainment Inc.
and The Game Holdings, Ltd. dated December 26, 2001.(1)
4.8 Promissory Note granted by The Game Holdings, Ltd. dated December
26, 2001.(1)
4.9 Form of Amended Share Purchase Agreement between VHQ Entertainment
Inc. and The Game Holdings, Ltd. dated effective February 1, 2002
(unsigned).(1)
4.10 Form of Promissory Note granted by The Game Holdings, Ltd. in favor
of VHQ Entertainment Inc. dated February, 2002 (unsigned).(1)
4.11 Services Agreement with TMH Holdings Ltd. dated effective April 1,
2001.(1)
4.12 Services Agreement with Summit Capital Corporation dated effective
April 1, 2001.(1)
4.13 Lease Agreement with G&J Holdings Inc. dated March 27, 1998.(1)
4.14 2001 Stock Option Plan.(1)
4.15 Employee Share Purchase Plan dated effective November 15, 2001.(1)
4.16 Line of Credit and Credit Facility with Community Savings.(1)
4.17 Canadian Prospectus. (1)
90
<page>
Exhibit
Number Description
- --------------------------------------------------------------------------------
4.18 Asset Purchase Agreement between Integrated Retail Corp. and
Softech 002 Limited Partnership dated September 29th, 1999.
10.1 Certification of Chief Executive Officer
10.2 Certification of Chief Financial Officer
- ------------------
(1) Filed previously.
91
SIGNATURES
The registrant hereby certifies that it meets all of the requirements for filing
on Form 20-F and that it has duly caused and authorized the undersigned to sign
this annual report on its behalf.
Date: December 17, 2002 By: /S/ TREVOR HILLMAN
-------------------------------------
TREVOR HILLMAN
Chief Executive Officer and
Chairman of the Board
92
CERTIFICATION
I, Trevor Hillman, certify that:
1. I have reviewed this annual report on Form 20-F of VHQ Entertainment
Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period
covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this annual report;
Date: December 17, 2002
------------------------------
Signed: /S/TREVOR HILLMAN
----------------------------
TREVOR HILLMAN, CHIEF EXECUTIVE OFFICER
93
CERTIFICATION
I, Derrek Wong, certify that:
1. I have reviewed this annual report on Form 20-F of VHQ Entertainment
Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period
covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this annual report;
Date: DECEMBER 17, 2002
----------------------------------------
Signed: /S/DERREK WONG
--------------------------------------
DERREK WONG, CHIEF FINANCIAL OFFICER
94
To the Shareholders of
VHQ Headquarters Inc.
We have audited the consolidated balance sheets of VHQ Entertainment Inc. as at
May 31, 2002, 2001 and 2000 and the consolidated statements of earnings (losses)
and retained earnings (deficit) and cash flow for the years ended May 31, 2002,
2001 and 2000. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audit.
We conducted our audits in accordance with Canadian and United States generally
accepted auditing standards. Those standards require that we plan and perform an
audit to obtain reasonable assurance 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.
In our opinion, these consolidated financial statements present fairly, in all
material respects, the financial position of the Company as at May 31, 2002,
2001 and 2000 and the results of its operations and cash flow for the years
ended May 31, 2002, 2001 and 2000 in accordance with Canadian generally accepted
accounting principles.
Canadian generally accepted accounting principles vary in certain significant
respects from accounting principles generally accepted in the United States.
Application of accounting principles generally accepted in the United States
would have affected assets and shareholders' equity as at May 31, 2002, 2001 and
2000 and results of operations for the years ended May 31, 2002, 2001 and 2000
to the extent summarized in Note 21 to the consolidated financial statements.
/s/ COLLINS BARROW
Chartered Accountants
Red Deer, Alberta
September 21, 2002, except for
Note 21 which is as of December 10, 2002
F-1
95
<page>
VHQ ENTERTAINMENT INC.
CONSOLIDATED BALANCE SHEET
(ALL FIGURES $ CDN)
<table>
<caption>
May 31,
2002 2001 2000
------------ ------------ ------------
(audited) (audited) (audited)
<s>
ASSETS
CURRENT
Cash 121,145 155,371 238,635
Accounts receivable 184,367 237,583 354,747
Inventory 1,860,242 1,561,352 789,971
Note receivable [NOTE 3] - - 884,009
Prepaid expenses and deposits 228,460 189,286 201,553
------------ ------------ ------------
2,394,214 2,143,592 2,468,915
INVESTMENT IN SUBSIDIARY [NOTE 4] - - 1,886,851
PROPERTY, PLANT AND EQUIPMENT
[NOTE 5] 10,184,482 8,575,627 6,827,334
GOODWILL AND INTANGIBLES [NOTE 6] 3,001,553 3,018,749 3,369,994
------------ ------------ ------------
15,580,249 13,737,968 14,553,094
============ ============ ============
LIABILITIES AND
SHAREHOLDERS' EQUITY
CURRENT
Bank indebtedness [NOTE 7] 1,150,358 800,556 69,231
Accounts payable and accrued 4,656,570 3,977,617 2,860,675
liabilities
Current portion of lease inducements 83,590 65,744 25,212
Current portion of capital assets
under lease 153,022 - -
Current portion of long-term debt 1,186,866 158,750 62,924
------------ ------------ ------------
7,230,406 5,002,667 3,018,042
DEFERRED LEASE INDUCEMENTS [NOTE 13] 305,192 291,676 108,684
CAPITAL ASSETS UNDER LEASE [NOTE 9] 235,538 - -
LONG-TERM DEBT [NOTE 8] 713,845 110,794 233,996
DUE TO RELATED COMPANY [NOTE 12] - 493,578 361,331
FUTURE INCOME TAXES [NOTE 11] 871,000 748,000 2,465,000
------------ ------------ ------------
9,355,981 6,646,715 6,187,053
SHAREHOLDERS' EQUITY
Share capital [NOTE 10] 9,108,803 7,626,499 6,087,766
Retained earnings (deficit) (2,884,535) (535,246) 2,278,275
------------ ------------ ------------
6,224,268 7,091,253 8,366,041
------------ ------------ ------------
15,580,249 13,737,968 14,553,094
============ ============ ============
COMMITMENTS [NOTE 13]
</table>
ON BEHALF OF THE BOARD OF DIRECTORS
BY: /s/ TREVOR M. HILLMAN BY: /s/ CATHERINE J. MCDONOUGH
DIRECTOR DIRECTOR
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
F-2
96
<page>
VHQ ENTERTAINMENT INC.
CONSOLIDATED STATEMENT OF EARNINGS (LOSSES) AND RETAINED EARNINGS (DEFICIT)
(ALL FIGURES $ CDN)
<table>
<caption>
Year Ended May 31,
----------------------------------------------
2002 2001 2000
------------ ------------ ------------
<s>
REVENUES
Rentals 20,474,085 16,579,831 10,205,031
Product sales 5,640,088 4,750,636 2,679,821
------------ ------------ ------------
TOTAL REVENUES 26,114,173 21,330,467 12,884,852
----------------------------------------------
COST OF SALES
Revenue sharing 2,112,239 1,772,261 625,743
Amortization of rental product 5,309,090 2,599,104 1,450,933
------------ ------------ ------------
Rental 7,421,329 4,371,365 2,076,676
Product sales 4,727,323 3,665,497 2,187,754
------------ ------------ ------------
TOTAL COST OF SALES 12,148,652 8,036,862 4,264,430
----------------------------------------------
GROSS MARGIN 13,965,521 13,293,605 8,620,422
----------------------------------------------
OPERATING COSTS AND EXPENSES
Store operating expenses 10,685,971 9,371,740 5,525,630
General and administrative 3,272,445 2,318,520 1,956,710
Amortization of intangibles 31,776 361,934 246,288
------------ ------------ ------------
TOTAL OPERATING COSTS AND 13,990,192 12,052,194 7,728,628
EXPENSES ----------------------------------------------
OPERATING INCOME (LOSS) (24,671) 1,241,411 891,794
Interest expense (net) 175,274 119,649 151,497
Interest - convertible debenture 44,491 - -
Video Limited Partnership
disbursements
[NOTE 12] 698,299 1,509,565 732,990
------------ ------------ ------------
INCOME (LOSS) BEFORE THE FOLLOWING: (942,735) (387,803) 7,307
Writedown from Buyout of VLP (1,315,779) - -
obligation [NOTE 2]
Write-down of investment [NOTE 4, 12] - (1,886,851) -
Write-down of property, plant and - (2,255,867 -
equipment [NOTE 17]
Minority interest [NOTE 4] - - 114,572
Equity loss of investment [NOTE 1, 4] - - (268,249)
Gain on dilution of investment - - 2,452,188
[NOTE 1,4]
Gain on disposal of property, plant and - - 1,297,049
equipment [NOTE 18] ------------ ------------ ------------
INCOME (LOSS) (2,258,514) (4,530,521) 3,602,867
Income tax (recovery) (32,225) - -
Future income taxes (recovery) 123,000 (1,717,000) 1,500,000
------------ ------------ ------------
NET INCOME (LOSS) (2,349,289) (2,813,521) 2,102,867
RETAINED EARNINGS (DEFICIT), (535,246) 2,278,275 175,408
BEGINNING OF THE PERIOD
----------------------------------------------
RETAINED EARNINGS (DEFICIT), (2,884,535) (535,246) 2,278,275
END OF THE PERIOD ============ ============ ============
EARNINGS (LOSS) PER SHARE [NOTE 15] (0.20) (0.24) 0.21
============ ============ ============
</table>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
F-3
97
<page>
VHQ ENTERTAINMENT INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(ALL FIGURES $ CDN)
<table>
<caption>
2002 2001 2000
------------ ------------ ------------
<s>
CASH WAS PROVIDED BY
(USED FOR):
Operating activities
Net income (loss) for the period (2,349,289) (2,813,521) 2,102,867
Add (deduct) items not affecting cash:
Amortization of property, plant 5,776,096 3,329,413 2,067,683
and equipment and intangibles
Amortization of lease inducements (166,047) (109,876) (21,042)
Writedown from Buyout of VLP 1,315,779
obligation [NOTE 4]
Write-down of capital assets - 2,255,867 -
[NOTE 17]
Write-down of investment [NOTE 4, 12] - 1,886,851 -
Minority interest - - (114,572)
Gain on dilution of investment - - (2,452,188)
Equity loss of investment - - 268,249
Gain on disposal of assets - - (1,297,049)
Future income taxes (recovery) 123,000 (1,717,000) 1,500,000
Net change in non-cash components
of working capital [NOTE 14]
Accounts receivable 53,216 117,164 (345,003)
Inventory (298,890) (771,381) (575,833)
Prepaid expenses (39,174) 12,267 (109,755)
Accounts payable 678,954 1,116,942 2,239,878
Working capital from acquisitions - 246,194 (23,608)
------------ ------------ ------------
5,093,645 3,552,920 3,239,627
------------ ------------ ------------
FINANCING ACTIVITIES
Proceeds from issue of share capital, 662,800 1,538,733 509,596
net of issuance costs
Proceeds from long-term debt 700,000 125,000 74,065
Repayment of long-term debt (349,308) (183,626) (89,369)
Increase (decrease) in short-term debt 349,802 731,325 69,231
Lease inducements received 197,409 333,400 62,227
Proceeds from capital assets under lease 506,237 - -
Repayment of capital assets under lease (117,678) - -
Advance from (payment to) related
company (493,578) 132,247 361,331
------------ ------------ ------------
1,455,684 2,677,079 987,081
------------ ------------ ------------
INVESTING ACTIVITIES
Acquisitions [NOTE 2] - (225,000) (2,750,000)
Dilution of subsidiary - - 406,345
Issuance of note receivable - - (925,000)
Repayment of note receivable - 884,009 40,991
Proceeds from disposal of 450 - 4,000,000
property, plant and equipment
Purchase of property, plant and equipment (6,584,005) (6,972,272) (4,989,913)
------------ ------------ ------------
(6,583,555) (6,313,263) (4,217,577)
------------ ------------ ------------
Increase (decrease) in cash for the period (34,226) (83,264) 9,131
CASH, BEGINNING OF THE PERIOD 155,371 238,635 229,504
------------ ------------ ------------
CASH, END OF THE PERIOD 121,145 155,371 238,635
============ ============ ============
CASH INTEREST PAID 233,368 116,415 145,892
</table>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
F-4
98
<page>
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
VHQ Entertainment Inc. ("the Corporation") is incorporated under the Canadian
Business Corporation Act and through its subsidiaries operates video and home
entertainment stores in Canada.
1. SIGNIFICANT ACCOUNTING POLICIES
BASIS OF CONSOLIDATION
The consolidated financial statements of the Corporation have been prepared in
accordance with generally accepted accounting principles in Canada and include
the accounts of the Corporation and its subsidiaries. Intercompany transactions
and balances have been eliminated on consolidation.
These consolidated financial statements include the accounts of the Corporation
and its wholly owned subsidiaries: Integrated Retail Corp., Safiqa Holdings
Ltd., Star Vision Enterprises Inc., and 705556 Alberta Ltd.
The excess of the acquisition costs of investment in subsidiaries over the
Company's proportionate share of the underlying value of the net assets at the
date of acquisition represents goodwill, and is amortized over periods not
exceeding 10 years. The value of goodwill, and any impairment of that value, is
assessed by reference to cash flows, operating income and estimation of fair
value. Effective June 1, 2001 the Company adopted Handbook Section 3062 no
further provisions for amortization of goodwill have been included in these
financial statements.
During the period June 1, 1999 to March 1, 2000 the Corporation included the
accounts of E-Trend Networks, Inc. (E-Trend), which was under common control, in
the accounts of the Corporation excluding minority interest.
Subsequent to March 1, 2000, the Corporation's investment in E-Trend was diluted
to 38.37%. Due to the loss in control of E-Trend, the Corporation adopted the
equity method of accounting for this investment.
MEASUREMENT UNCERTAINTY
Because a precise determination of many assets and liabilities is dependent upon
future events, the preparation of financial statements for a period necessarily
involves the use of estimates and approximations which have been made using
careful judgment. The consolidated financial statements have, in management's
opinion, been properly prepared within reasonable limits of materiality and
within the framework of the accounting policies summarized below.
F-5
99
<page>
INVENTORY
Inventory, consisting primarily of filmed entertainment on VHS and DVD formats,
video games and CD music for resale, studio merchandise, video-gaming
accessories and confectionery items, is valued at the lower of cost (determined
on an average invoice cost) and net realizable value.
REVENUE RECOGNITION
Due to the short term nature of the rental of VHS, DVDs and video games, revenue
is recognized at the time of the rental. Where the Corporation has entered into
revenue sharing agreements, the revenues are recorded on a gross basis with an
offset to cost of sales. Where the Corporation sells VHS, DVDs and games that
have been previously used to earn rental revenue, the Corporation records the
sale in rental revenue and reduces the carrying value of its rental assets using
the net book value.
Revenue from the sale of product is recognized at the point of sale.
PRE-OPENING COSTS
Pre-opening costs are expensed as they are incurred.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are recorded at cost. Amortization is provided
using the following rates and methods to amortize the costs, net of any salvage
values, over their estimated useful lives:
Canopies and signs 20% straight line
Capital assets under lease 10% declining balance
Equipment and fixtures 10% declining balance
VCRs, TVs and game players 30% declining balance
VHS, DVDs and video games 12 month straight line
Computer hardware 30% declining balance
Computer software 20% declining balance
Leasehold improvements Over term of the lease plus
one renewal period
Logo and jingle 3 years straight line
Uniforms 2 years straight line
Effective May 31, 2001, the Corporation changed its method of amortization of
its rental product (VHS, DVDs, and video games). This method accelerates the
rate of amortization and was adopted as a result of an industry trend towards
significant increases in copy depth availability from movie studios and revenue
sharing agreements that have resulted in earlier satisfaction of consumer
demand, thereby accelerating the rate of revenue recognition. As a result of the
change, the Corporation has revised its estimate of the useful life of its
rental product to a 12-month period of amortization from a 24-month period. This
change has been applied prospectively.
F-6
100
<page>
During the year ended May 31, 2001 the Corporation reviewed the carrying value
of its rental product and determined that the carrying value exceeded the net
realizable value and resulted in a one-time write-down of property, plant and
equipment, as a result of this review, effective May 31, 2001, the Corporation
changed its estimate of the salvage value of its VHS and DVD movies and video
games from $7 per unit to $5, $10, and $15, respectively. This change has been
applied prospectively
As a result of this change, amortization of rental product and net loss for the
year ended May 31, 2002 was increased by $2,654,545. The related loss per share
amount, as a result of this change for the nine-month period ended February 28,
2002 was increased $.08 per share.
GOODWILL AND INTANGIBLES
Intangibles such as logos and jingles, trademarks and other intangibles are
being amortized on a straight-line basis over periods of 3 to 15 years.
In accordance with new accounting standards introduced in 2001, goodwill and
intangibles with indefinite useful lives will not amortize but be tested
annually for impairment. The Corporation reviews the goodwill annually to
determine if the carrying value exceeds the fair value. Where the carrying value
exceeds the fair value, a charge against net income is recorded in the period
that the impairment has occurred. Based on management's review in 2002, the
Corporation does not believe that an impairment of the carrying value of
goodwill has occurred and no provision for impairment has been made in these
financial statements.
FUTURE INCOME TAXES
Future income tax assets and liabilities are recognized for the future income
tax consequences attributable to the carrying value of the assets reported on
the financial statements to the tax value as determined by Canada Customs &
Revenue Agency. Future income tax assets or liabilities are measured using the
tax rates expected to apply to taxable income in the years in which the
temporary differences are expected to reverse.
Income tax expense of the Corporation is the sum of current income taxes and the
difference between opening and ending balances of future income tax assets and
liabilities.
FINANCIAL INSTRUMENTS
Financial instruments of the Corporation consist mainly of cash and cash
equivalents, accounts receivable, bank indebtedness, accounts payable and
accrued liabilities and long term liabilities. There are no significant
differences between the carrying amounts of these items and their estimated fair
values.
STOCK BASED COMPENSATION PLAN
The Corporation has a stock option plan and may grant options to employees to
acquire common shares. No compensation expense is recognized when stock or stock
options are issued to employees. Consideration paid by employees on the exercise
of stock options is credited to share capital.
The Corporation introduced an employee share ownership plan to all employees in
2002. Under this plan, employees are entitled to have a portion of their
earnings withheld to purchase common stock in the Corporation. The Corporation's
contributions are charged to earnings.
F-7
101
<page>
CONSOLIDATED STATEMENT OF CASH FLOWS
The Corporation uses the indirect method of reporting its consolidated statement
of cash flows.
SEGMENTED INFORMATION
The Corporation does not disclose segmented information as the Corporation
engages in and monitors only one operating segment. The Corporation's geographic
segment is within the Canadian market.
2. ACQUISITIONS
Effective December 1, 2001, the Corporation acquired all the units of Video
Limited Partnership for total consideration of $2.1 million.
$
------------------
CONSIDERATION PAID
Convertible debenture 1,280,475
Common stock 819,504
------------------
2,099,979
==================
The consideration given under the acquisition agreement was 546,336 units, each
comprised of one common share of the Corporation and one half of one common
share purchase warrant and a $1.28 million principal amount three year,
composite, subordinated, convertible debenture. Each whole warrant issued as
part of the units is exercisable to purchase one common share until December 2,
2003 at $2.00 per share. The rate of interest on the debenture is 8% per annum
with blended monthly principal and interest payments. The principal amount of
the debenture can be converted at any time into common shares of the Corporation
at the option of the holder at $2.50 per share until December 1, 2003 and at
$3.00 per share until December 1, 2004.
Of the $2,099,980 purchase price for the Video Limited Partnership units,
$777,660 was allocated to property, plant and equipment, specifically 155,532
VHS tapes representing the salvage value of the rental assets at the purchase
date. The remaining $1,322,320 was written off as a one time charge to net
income representing the extinguishment of future cash payments under the
original revenue sharing contract with Video Limited Partnership.
On July 11, 2000, the Corporation acquired the assets of M & K Video Spot Inc.,
an independent video retailer operating one video store in Stony Plain, Alberta
and one video store in Spruce Grove, Alberta under the name "Five Star Movies".
On June 15, 2000, the Corporation's wholly owned subsidiary Star Vision acquired
from Raeco Holdings Incorporated all of the assets of a video and home
entertainment store operating under the name "Silver Screen Video" in Saskatoon,
Saskatchewan.
F-8
102
<page>
Five Star Silver Screen
Movies Video
------------- -------------
Assets Acquired
Capital Assets $425,000 $200,000
-------------------------------
$425,000 $200,000
-------------------------------
Consideration
Cash $125,000 $100,000
Note Payable 125,000 - -
Share Capital 175,000 100,000
-------------------------------
$425,000 $200,000
===============================
During the period ended May 31, 2000, the Corporation acquired all of the issued
and outstanding shares of 705556 Alberta Ltd., Star Vision Enterprises Inc., and
Safiqa Holdings Ltd. Each Corporation is engaged in the operations of video
rental and retail stores in Canada. The acquisitions have been accounted for
using the purchase method of accounting as follows:
<table>
<caption>
705556 Star Vision Safiqa
Alberta Enterprises Inc. Holdings
Ltd. Ltd. Total
$ $ $ $
------------- ---------------- --------------- -------------
<s>
Assets Acquired
Working capital (7,768) (23,609) -- (31,377)
Capital assets 414,490 1,572,043 1,058,248 3,044,781
Goodwill 343,278 1,809,566 1,372,752 3,525,596
Deferred taxes (125,000) (444,000) (306,000) (875,000)
-----------------------------------------------------------------------
625,000 2,914,000 2,125,000 5,664,000
=======================================================================
Consideration
Cash 250,000 1,500,000 1,000,000 2,750,000
Common shares 375,000 1,414,000 1,125,000 2,914,000
-----------------------------------------------------------------------
625,000 2,914,000 2,125,000 5,664,000
=======================================================================
</table>
On August 1, 1998, the Company acquired all of the issued and outstanding shares
of Integrated Retail Corp. for consideration of 5,200,000 common shares and
warrants of the Company. Both of these companies have been controlled by the
same individuals since inception, therefore, there was no substantive change in
ownership of the shares. As the companies were under common control and the
Company had no operation or assets prior to the transaction with Integrated
Retail Corporation, this transaction has been accounted for as a
re-capitalization of Integrated Retail and the issuance of shares for the net
assets of the Company. Accordingly, as at May 31, 2000 and 1999, the
consolidated balance sheets include the assets and liabilities of the Company
and Integrated at their carrying values and the consolidated statements of
earnings and retained earnings (deficit) and cash flows include the results of
their operations for all periods presented
F-9
103
<page>
3. NOTE RECEIVABLE
The Note was due on demand from Video Limited Partnership, bore interest at 15%
per annum and was unsecured. The Note was paid in full on January 19, 2001.
4. INVESTMENT IN SUBSIDIARY
The Corporation consolidated the financial statements of its subsidiary, E-Trend
up to February 29, 2000.
Between the period from September, 1999 to February 29, 2000, the Corporation's
ownership was diluted to 45.18% through the issuance by E-Trend of common shares
from treasury. As a result of the dilution of the Corporation's ownership of
E-Trend, the Corporation's interest in E-Trend was subsequently accounted for by
the equity method of accounting and a dilution gain of $2,452,188 was recorded.
E-Trend reported a net loss during the period of March 1, 2000 to May 31, 2000.
The Corporation's share of this loss was $268,249.
On May 31, 2001, the Corporation wrote down its investment in E-Trend resulting
in a one-time charge of $1,886,851 to net income.
On December 21, 2001, the Corporation entered into an agreement to sell its
entire holdings of 2,000,000 common shares of E-Trend to The Game Holdings,
Ltd., a British Virgin Islands corporation, for US$0.40 per share, for a total
price of US$800,000. The purchase price was paid by way of a secured promissory
note of The Game Holdings payable as follows: (a) US$10,000 per month from
January 2002 until March 2002; (b) US$30,000 per month from April 2002 until May
31 2003; and (c) the remainder of the purchase price on June 30, 2003. The
promissory note bears interest at a rate of 6% per annum and is secured by way
of a second charge against a yacht owned by The Game Holdings which, as at June
22, 2001, had an estimated market value of approximately US$1,600,000 and a
replacement value of approximately US$2,000,000, as determined by an independent
appraiser. To date, the Corporation has not received any payments from The Game
Holdings as required by the terms of the promissory note. As the payments are
received, a gain on the sale will be recognized. The Corporation believes that
this asset has a nominal fair value.
F-10
104
<page>
5. PROPERTY, PLANT AND EQUIPMENT
<table>
<caption>
May 31, 2002
-------------------------------------------------
Accumulated Net Book
Cost Amortization Value
$ $ $
-------------- --------------- --------------
<s>
Canopies and signs 607,046 263,919 343,127
Capital assets under lease 506,237 50,624 455,613
Equipment and fixtures 2,133,535 855,531 1,278,004
VCRs, TVs, DVD and game players 490,234 311,098 179,136
Rental product 19,765,826 12,869,035 6,896,791
Computer hardware 621,109 462,789 158,320
Computer software 439,775 195,194 244,581
Leasehold improvements 862,247 256,253 605,994
Uniforms 73,881 50,965 22,916
--------------------------------------------------
25,499,890 15,315,408 10,184,482
==================================================
</table>
<table>
<caption>
May 31, 2002
-------------------------------------------------
Accumulated Net Book
Cost Amortization Value
$ $ $
-------------- --------------- --------------
<s>
Canopies and signs 492,738 178,137 314,601
Equipment and fixtures 2,074,197 720,041 1,354,156
VCRs, TVs, DVD and game players 420,883 234,325 186,558
Rental product 13,468,906 7,636,718 5,832,188
Computer hardware 591,739 394,937 196,802
Computer software 374,973 134,049 240,924
Leasehold improvements 684,921 247,250 437,671
Uniforms 44,867 32,140 12,727
---------------------------------------------------
18,153,224 9,577,597 8,575,627
===================================================
</table>
<table>
<caption>
May 31, 2002
-------------------------------------------------
Accumulated Net Book
Cost Amortization Value
$ $ $
-------------- --------------- --------------
<s>
Canopies and signs 295,323 89,129 206,194
Equipment and fixtures 1,876,713 660,255 1,216,458
VCRs, TVs, DVD and game players 188,559 81,788 106,771
Rental product 8,267,602 3,697,698 4,569,904
Computer hardware 481,195 323,913 157,282
Computer software 281,010 80,173 200,837
Leasehold improvements 526,441 160,103 366,338
Logo and jingle 3,250 2,617 633
Uniforms 27,220 24,303 2,917
---------------------------------------------------
11,947,313 5,119,979 6,827,334
===================================================
</table>
F-11
105
<page>
Amortization of rental assets is included in cost of goods sold in the amount of
$5,309,090; $2,599,104; and $1,450,933, is included in the cost of rental
revenues for the years ended May 31, 2002, May 31, 2001, and May 31, 2000.
Amortization of other related store capital assets is included in store
operating expenses.
6. GOODWILL AND INTANGIBLES
<table>
<caption>
May 31, 2002
-------------------------------------------------
Accumulated Net Book
Cost Amortization Value
$ $ $
-------------------------------------------------
<s>
Intangibles 267,183 70,504 196,679
Goodwill (indefinite life) 3,360,956 566,827 2,794,129
Logo and jingles 18,250 8,250 10,000
Trademarks 860 115 745
-------------------------------------------------
3,647,249 645,696 3,001,553
=================================================
</table>
<table>
<caption>
May 31, 2002
-------------------------------------------------
Accumulated Net Book
Cost Amortization Value
$ $ $
-------------------------------------------------
<s>
Intangibles 267,183 43,786 223,397
Goodwill (indefinite life) 3,360,956 566,827 2,794,129
Logo and jingles 3,250 3,250 ---
Trademarks 1,310 87 1,223
-------------------------------------------------
3,632,699 613,950 3,018,749
=================================================
</table>
<table>
<caption>
May 31, 2002
-------------------------------------------------
Accumulated Net Book
Cost Amortization Value
$ $ $
-------------------------------------------------
<s>
Intangibles 258,437 18,668 239,769
Goodwill (indefinite life) 3,360,956 230,731 3,130,225
-------------------------------------------------
3,619,393 249,399 3,369,994
=================================================
</table>
F-12
106
<page>
In accordance with the recommendations of Section 3062, no provision has been
made in these financial statements for amortization of goodwill. As prescribed
by the transitional provision of the new recommendations, this change has been
applied prospectively.
2002 2001 2000
$ $ $
-------------------------------------------
Net Income Reported (2,349,289) (2,813,521) 2,102,867
-------------------------------------------
Add back: Goodwill
amortization - 361,301 245,203
-------------------------------------------
Net Income (Loss)
Restated (2,349,289) (2,452,220) 2,348,070
===========================================
Weighted Average
Shares Outstanding 11,903,465 11,490,281 10,086,383
===========================================
Reported EPS (0.20) (0.24) 0.21
===========================================
Adjusted EPS (0.20) (0.21) 0.23
===========================================
Amortization of intangibles in the amount of $31,776; $361,934; and $246,288 has
been recognized as a separate category in operating costs and expenses, for
years ended May 31, 2002, May 31, 2001, and May 31, 2000.
7. BANK INDEBTEDNESS
The Corporation has two demand operating credit facilities with Canadian
financial institutions providing for overdrafts which have maximum limits in the
amounts of $800,000 and $200,000. The credit facilities bear interest at prime
plus 1% (2001 - 7.25%) and prime plus 0.5% (6.75%), respectively.
As at May 31, 2002, the outstanding balance under these credit facilities is
$849,877 with the net of outstanding cheques less funds held on deposit of
$300,481.
8. LONG-TERM DEBT
<table>
<caption>
May 31 May 31 May 31
2002 2001 2000
$ $ $
---------- ---------- ---------
<s>
Demand loan, due in blended monthly principal and 294,725 - -
interest payments of $12,398. Interest at prime plus 1%
per annum secured by a general security agreement on all
assets of the Corporation.
Promissory note, due on September, 2002 bearing interest 77,299 77,299 74,065
at 9% per annum secured by a personal guarantee of a
shareholder.
F-13
107
<page>
<caption>
<s>
Promissory note from a director of the Corporation, due 100,000 - -
in monthly installments of $8,772 plus interest at 10%
per annum. The note is secured by a general security
agreement covering assets of one store located in
Saskatoon, Saskatchewan. The final payment of the loan
is due May 6, 2003.
Promissory note, due on demand plus interest at 1% per 200,000 - -
month. The promissory note is unsecured.
Small business loan, due in blended monthly principal 108,277 160,995 205,483
and interest payments of $5,250. Interest at prime plus
3% per annum, secured a by a general security agreement
on all assets of the Corporation.
Convertible debenture, due in blended monthly principal 1,120,410 - -
and interest payments of $40,125 maturing December 1,
2004; interest calculated at 8% per annum. The
principal amount of the debenture can be converted into
common shares of the Corporation at $2.50 per share
until December 1, 2003 and at $3.00 per share until
December 1, 2004.
Promissory note, due in monthly installments of $10,417 - 31,250 -
plus interest at 9% per annum secured by a general
security agreement covering assets located in Spruce
Grove and Stony Plain.
Other - - 17,372
---------------------------------------------
1,900,711 269,544 296,920
Less current portion 1,186,866 158,750 62,924
---------------------------------------------
713,845 110,794 233,996
=============================================
</table>
Estimated principal payments over the next three years are as follows:
$
-----------
2003 1,186,866
2004 440,310
2005 273,535
-----------
1,900,711
===========
F-14
108
<page>
9. OBLIGATIONS UNDER CAPITAL LEASES
The Corporation has entered into a number of capital leases with monthly
payments ranging from $731 to $1991 including interest rates varying from 13% to
17%. The leases expire between April 2004 and June 2005. The principal plus
interest payments for the next four years are as follows:
YEAR ENDING PRINCIPAL INTEREST TOTAL
$ $ $
2003 153,022 45,368 198,390
2004 174,596 22,082 196,678
2005 59,879 2,813 62,692
2006 1,063 12 1,075
-------------------------------------------------------
388,560 70,275 458,835
Current portion (153,022) (45,368) (198,390)
-------------------------------------------------------
235,538 24,097 260,445
=======================================================
10. SHARE CAPITAL
AUTHORIZED
Unlimited number of preferred shares
Unlimited number of common shares
Common Shares Issued Number of Shares $
--------------------------------- ------------------ ---------------
Balance, May 31, 1999 8,497,276 2,664,170
-------------------------------------
Exercise of options 200,000 40,000
Exercise of warrants 316,575 395,719
Exercise of broker options 59,372 44,529
Issued for acquisitions [NOTE 2] 1,996,207 2,914,000
Issued for cash 25,833 33,750
Share issue costs - - (4,402)
-------------------------------------
Balance, May 31, 2000 11,095,263 6,087,766
-------------------------------------
F-15
109
<page>
Issued for acquisitions [NOTE 2] 68,750 275,000
Issued for cash 366,754 1,375,289
Share issue costs - - (111,556)
-------------------------------------
Balance, May 31, 2001 11,530,767 7,626,499
-------------------------------------
Issued for cash 461,456 685,400
Issued for acquisitions 546,336 819,505
Share issue costs - (22,601)
-------------------------------------
Balance, May 31, 2002 12,538,559 9,108,803
-------------------------------------
OPTIONS AND WARRANTS
The Corporation has a stock option plan available to officers, directors and
employees with grants under the plan approved from time to time by the Board of
Directors. The exercise price of each option equals the market price of the
Company's stock at the date of grant. The plan provides for vesting at the
discretion of the Board and the options expire after five years from the date of
grant.
The Corporation has issued the following stock options:
Weighted
average
exercise price
Shares ($)
-------------- --------------
Granted during the year 200,000 0.20
----------------------------------
Outstanding as at May 31, 1999 200,000 0.20
Granted during the year 1,000,000 1.51
Cancelled during the year (200,000) 0.20
----------------------------------
Outstanding as at May 31, 2000 1,000,000 1.51
Granted during year 142,200 2.68
----------------------------------
Outstanding as at May 31, 2001 1,142,200 1.66
Granted during the period 1,017,500 1.90
Cancelled during the period (102,400) 1.53
----------------------------------
Outstanding as at May 31, 2002 2,057,300 1.78
==================================
Options exercisable as at May 31, 2002 1,649,379 1.72
==================================
F-16
110
<page>
As of May 31, 2002, the Corporation has the following warrants to purchase
common shares outstanding:
<table>
<caption>
Warrants Outstanding Date Issued Date of Expiration Exercise Price
-------------------- --------------- ------------------ ------------------------------
<s>
240,205 June 28, 2000 June 28, 2002 Exercisable at $5.00 per
share until June 28, 2001;
$6.00 per share until June
28, 2002
110,862 Aug 31, 2000 Aug 31, 2002 Exercisable at $5.00 per
share until Aug 31, 2001;
$6.00 per share until Aug 31,
2002
15,666 Oct 18, 2000 Oct 18, 2002 Exercisable at $5.00 per
share until Oct 18, 2001;
$6.00 per share until Oct 18,
2002
114,850 Aug 7, 2001 Aug 7, 2003 Exercisable at $2.50 per
share until Aug 7, 2003
273,168 Dec 1, 2001 Dec 1, 2003 Exercisable at $2.00 per
share until Dec 1, 2003
226,000 May 31, 2002 May 31, 2004 Exercisable at $2 per share
for the first year, $2.50 per
share for the second year.
</table>
11. INCOME TAXES
The components of future tax assets and liabilities are as follows:
For the For the For the
year ended year ended year ended
May 31, May 31, May 31,
2002 2001 2000
$ $ $
----------------------------------------
FUTURE INCOME TAX ASSETS
Share issue costs (36,500) (49,000) (38,000)
Promissory note from E-Trend. sale (454,000) - -
----------------------------------------
(490,500) (49,000) (38,000)
========================================
FUTURE INCOME TAX LIABILITIES
Difference between tax and accounting 1,181,000 797,000 1,938,000
basis of property, plant and equipment
Book value of investment in excess of - - 565,000
adjusted cost base
Capital gain reserve 180,500 - -
----------------------------------------
1,361,500 797,000 2,503,000
========================================
871,000 748,000 2,465,000
========================================
F-17
111
<page>
The provision for income taxes differs from the provision amount calculated at
combined statutory federal and provincial tax rates for the following reasons:
<table>
<caption>
For the For the For the
year ended year ended year ended
May 31, May 31, May 31,
2002 2001 2000
$ $ $
-----------------------------------------------------
<s>
Computed income taxes (recovery) at 35.76% (2001 - (807,645) (1,743,344) 1,620,570
38.48%, 2000 - 44.98%)
Non-deductible expenses 13,470 38,480 -
Amortization of intangibles 181,596 129,330 106,153
Gain on disposal of assets and asset write-downs 470,523 241,676 (30,000)
Dilution of investment - - (196,723)
Effect of substantially enacted tax rates (52,875) (356,214) -
Limited partnership income allocation 521,570 - -
Non-taxable portion of capital gain (225,604) - -
Debt settlement 21,965 - -
Investment writedown - (26,928) -
-----------------------------------------------------
123,000 (1,717,000) 1,500,000
=====================================================
</table>
12. RELATED PARTY TRANSACTIONS
As at May 31, 2001 the amount due to a related corporation was due to E-Trend,
had no fixed terms of repayment, bore interest at bank prime plus 1% per annum,
(8% at May 31, 2001), and was unsecured. This amount was repaid in full as at
November 30, 2001.
Between the period from September 1999 to February 29, 2000, the Corporation's
ownership was diluted to 45.18% through the issuance by E-Trend of common shares
from treasury. As a result of the dilution of the Corporation's ownership of
E-Trend, the Corporation's interest in E-Trend was subsequently accounted for by
the equity method of accounting and a dilution gain of $2,452,188 was recorded.
E-Trend reported a net loss during the period of March 1, 2000 to May 31, 2000.
The Corporation's share of this loss was $268,249.
On May 31, 2001, the Corporation wrote down its investment in E-Trend resulting
in a one-time charge of $1,886,851 to net income.
Included in accounts payable as at May 31, 2001 are amounts due to Langara
Distribution Inc., a wholly owned subsidiary of E-Trend: $470,315 (May 31, 2001)
and $94,251 (May 30, 2000).
The Corporation entered into a revenue sharing agreement with Video Limited
Partnership whereby the two parties agreed to share revenues generated by
certain rental assets in certain of the Corporation's stores. Certain partners
of Video Limited Partnership are also directors and shareholders of the
Corporation. Disbursements paid to Video Limited Partnership relate to the terms
under this revenue sharing agreement. Effective December 1, 2001, the
Corporation acquired 100% of the partnership units of Video Limited Partnership
for total consideration of $2.1 million ($580,482 paid to partners who are also
directors of the Corporation), as disclosed in Note 2. The Corporation paid
$698,299 for the year
F-18
112
<page>
ending May 31, 2002, $1,509,565 for the year ending May 31, 2001 and $732,990
for the year ending May 31, 2000 under this revenue sharing agreement.
The Corporation has transactions in the normal course of business with related
companies. These amounts are measured at the exchange amounts. During the year,
the Corporation recorded $679 (2001 - $7,397) of purchases from E-Trend, a
related party. The Corporation also recorded purchases of music product from
Langara Distribution Inc. (a wholly owned subsidiary of E-Trend) of $1,207,074,
2001 - $2,152,441.
The Corporation sold its interest in E-Trend as disclosed in Note 16 of these
financial statements.
13. COMMITMENTS
The Corporation is committed to the following rental payments under leases for
various premises:
$
------------
2003 3,094,289
2004 2,888,620
2005 2,550,598
2006 2,339,684
2007 1,879,173
Thereafter 3,852,552
16,604,916
=============
With respect to the above leases, the Corporation received certain lease
inducements, which are being amortized and offset against rent expense over the
terms of the leases. Rent expense is included in store operating expenses. The
lease inducements to be amortized over the next five years are as follows:
2003 2004 2005 2006 2007 Thereafter
-------- -------- -------- -------- --------- ----------
$ 83,590 72,742 61,016 55,105 28,496 87,833
OPERATING LEASES
The Corporation is committed to a number of operating leases that expire from
dates ranging June 2002 to July 2005. The future minimum lease payments under
operating leases for equipment, vehicles and other contracts are as follows:
$
-------------
2003 139,644
2004 79,439
2005 23,788
2006 2,657
-------------
245,528
=============
F-19
113
<page>
EMPLOYMENT AGREEMENTS
The Corporation has employment agreements with four officers that entitle them
to a percentage of gross revenues of the Corporation. Two of these agreements
require payments of 0.5% each of the Corporation's gross revenues. One agreement
requires payments of 1% of the gross realized by the operation of certain retail
stores operated within the Province of Saskatchewan. One agreement requires
payments of 1% of the gross realized by the operation of certain retail stores
operated within the City of Calgary. During the years ending May 31, 2002 -
$361,154; May 31, 2001 - $120,894 and May 31, 2000 - $48,529 was paid to the
officers under these employment agreements.
The Corporation sources its VHS tapes, DVDs and video game product for rent and
for sale through formal supply contracts with certain suppliers and movie
studios, the earliest of which contract expires on January 30, 2003 and the
latest of which contract expires on December 31, 2009.
14. CHANGE IN NON-CASH COMPONENTS OF WORKING CAPITAL
<table>
<caption>
For the For the For the
year ended year ended year ended
May 31, May 31, May 31,
2002 2001 2000
$ $ $
--------------------------------------------------
<s>
Accounts receivable 53,216 117,164 (345,003)
Inventory (298,890) (771,381) (575,833)
Prepaid expenses and deposits (39,174) 12,267 (109,755)
Working capital from acquisitions - 246,194 (23,608)
Accounts payable and accrued liabilities 678,954 1,116,942 2,239,878
--------------------------------------------------
394,106 721,186 1,185,679
==================================================
</table>
15. EARNINGS (LOSS) PER SHARE
The earnings (loss) per share has been calculated based on the weighted average
number of common shares outstanding for the fiscal periods ended May 31, 2002 of
11,903,465, May 31, 2001 of 11,490,281, and May 31, 2000 of 10,086,383. The
Corporation has adopted the treasury stock method to compute dilutive effects of
stock options, warrants and convertible debentures on earnings (loss) per share.
Based on this method, the options, warrants and convertible debentures do not
have a dilutive effect on the earnings (loss) per share.
16. DISPOSAL OF SUBSIDIARY
On May 31, 2001, the Corporation wrote down its investment in E-Trend. On
December 21, 2001, the Corporation entered into an agreement to sell its entire
holdings of 2 million common shares of E-Trend, to a foreign company for US$0.40
per share. The purchase price was to be paid by way of a secured promissory note
with interest at 6% per annum. To date, the Corporation has not received any
payments as required by the terms of the promissory note. As the collectability
of the promissory note is unknown, the Corporation has not recorded any
receivables or gains in these financial statements. A gain on the disposal of
the asset will be recorded if any future payments of the promissory note are
received.
F-20
114
<page>
17. WRITE DOWN OF PROPERTY, PLANT AND EQUIPMENT
During the year ended May 31, 2001, the Corporation reviewed the carrying value
of its rental product and determined that the carrying value exceeded the net
realizable value and resulted in a one-time write down of property, plant and
equipment in the amount of $2,255,867.
As a result of this write down the Corporation changed its estimation of the
useful life and salvage values of its rental product. The Corporation has
revised its estimates of the useful life of rental product to a 12 month
amortization period from a 24 month amortization period and has reduced its
estimate of the salvage value from $7 per item to $5 per VHS, $10 per DVD and
$15 per video game. This change has been applied prospectively as a change in
accounting estimate.
18. GAIN OF DISPOSAL OF PROPERTY, PLANT AND EQUIPMENT
Effective September 30, 1999, the Corporation sold existing video-tapes, video
games and DVD's used for rental revenue to Video Limited Partnership for cash of
$4,000,000 resulting in a gain of $1,297,049. Video Limited Partnership
contracted the Corporation to manage these assets for which the Corporation
earned a revenue sharing fee. As of May 31, 2000, the Corporation earned
$2,226,813 under the contract with Video Limited Partnership. The Corporation
has subsequently acquired the units of the Video Limited Partnership, as
detailed in Note 2.
19. CONTINGENCIES
The Corporation has signed an irrevocable letter of credit in favor of two
suppliers for $100,000 and $25,000 respectively.
20. COMPARATIVE AMOUNTS
Certain comparative figures have been adjusted to conform to the current year's
financial statement presentation.
21. US GAAP RECONCILATION
Reconciliation of Canadian and United States Generally Accepted Accounting
Principles:
The consolidated financial statements of the Company are prepared in accordance
with generally accepted accounting principles in Canada ("Canadian GAAP") which,
in most respects, conform to generally accepted accounting principles in the
United States ("US GAAP"). Significant differences between Canadian and US GAAP
are as follows:
Net income (loss):
Year ended May 31,
---------------------------------------------
2002 2001 2000(F)
---- ---- -------
- --------------------------------------------------------------------------------
Net income (loss) under $(2,349,289) $(2,813,521) $2,102,867
Canadian GAAP
- --------------------------------------------------------------------------------
Gain on disposal of assets (a) (1,297,049)
- --------------------------------------------------------------------------------
VLP disbursements (a) 698,299 1,509,565 732,990
- --------------------------------------------------------------------------------
Interest expense (a) (473,000) (1,007,000) (489,000)
- --------------------------------------------------------------------------------
Depreciation expense (a) (404,000) (809,000) (472,000)
- --------------------------------------------------------------------------------
Write-down of assets (a) 1,315,779 - -
- --------------------------------------------------------------------------------
Gain on settlement of debt (a) 690,000 - -
- --------------------------------------------------------------------------------
F-21
115
<page>
- --------------------------------------------------------------------------------
Gain on dilution (b) (2,452,188)
- --------------------------------------------------------------------------------
Stock-based compensation (c) - (36,000) (1,041,000)
- --------------------------------------------------------------------------------
Income tax effect (d) - (1,340,000) 2,088,000
------------ ------------ ------------
- --------------------------------------------------------------------------------
Net income (loss) under US $(522,211) $(4,495,956) $(827,410)
GAAP ============ ============ ============
- --------------------------------------------------------------------------------
Earnings (loss) per share (e):
- --------------------------------------------------------------------------------
Primary $.04 $(.42) $(.09)
- --------------------------------------------------------------------------------
Diluted $.04 $(.42) $(.09)
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
Balance sheet items:
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
Capital assets:
- --------------------------------------------------------------------------------
Balance under Canadian $10,184,482 $8,575,627 $6,827,334
GAAP
- --------------------------------------------------------------------------------
Effect of accounting for - 1,422,049 2,231,049
VLP (a) ------------ ------------ ------------
- --------------------------------------------------------------------------------
Balance under US GAAP $10,184,482 $9,997,676 $9,058,383
============ ============ ============
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
Long-term debt:
- --------------------------------------------------------------------------------
Balance under Canadian $949,383 $110,794 $233,996
GAAP
- --------------------------------------------------------------------------------
Effect of accounting for - 3,253,229 3,755,914
VLP (a) ------------ ------------ ------------
- --------------------------------------------------------------------------------
Balance under US GAAP $949,383 $3,364,023 $3,989,910
============ ============ ============
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
Deferred tax asset (liability):
- --------------------------------------------------------------------------------
Balance under Canadian $(871,000) $(748,000) $(2,465,000)
GAAP:
- --------------------------------------------------------------------------------
Tax effect of US GAAP 748,000 748,000 2,088,000
differences ------------ ------------ ------------
- --------------------------------------------------------------------------------
Balance under US GAAP $123,000 $0 $(377,000)
============ ============ ============
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
Shareholders' equity:
- --------------------------------------------------------------------------------
Balance under Canadian $6,224,268 $7,091,253 $8,366,041
GAAP
- --------------------------------------------------------------------------------
Effect of income statement 743,584 (1,083,494) 562,941
adjustments ------------ ------------ ------------
- --------------------------------------------------------------------------------
Balance under US GAAP $6,967,852 $6,007,759 $8,928,982
============ ============ ============
- --------------------------------------------------------------------------------
(a) Video Limited Partnership transaction - In September 1999, the Company
sold existing video tapes, video games and DVD rental inventory to a
limited partnership and recorded a gain on disposal of the assets of
$1,297,049. The Company managed the rental of these products and was
responsible for replacing them as they were sold or became redundant.
The Company and the limited partnership shared the rental income from
the inventory. In December 2001, the Company acquired the assets of the
limited partnership for total consideration of $2.1 million. Under US
GAAP, this transaction is considered to be a financing transaction,
whereby the proceeds received would be shown as debt. Payments to the
limited partnership are allocated between reduction of debt and
interest expense based the buy-out formula in the sales agreement.
Depreciation expense related to this rental inventory would also be
recorded under US GAAP. The acquisition of the limited partnership
assets is treated as a settlement of debt under US GAAP.
(b) Gain on dilution - In September 1999 and May 2000, the Company's
subsidiary, E-Trend Networks, issued additional shares of its stock at
prices greater than the Company's original cost basis. Under Canadian
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GAAP, the increase in the Company's investment related to these
transactions is recorded as a gain. Under US GAAP, this increase is
recorded as an equity transaction.
(c) Stock-based compensation - During fiscal 2000 and 2001, the company
issued certain stock options to employees which had exercise prices
below the market price of the company's common stock. Under US GAAP,
compensation expense is recognized for the difference between the
exercise price of the option and the market price of the stock.
(d) Income tax effect - This item represents the income tax effect of the
other US GAAP differences.
(e) Earnings per share - Under US GAAP, shares held in escrow that are to
be released pursuant to performance criteria are not considered
outstanding for earnings per share purposes. The company had total of
1,130,000 shares escrowed subject to performance criteria that were
released as follows: 753,334 on November 15, 2000 and 376,666 on
September 18, 2001. The effect of these escrowed shares was to decrease
the weighted average shares outstanding by 1,130,000 shares for the
year ended May 31, 2000, 722,000 shares for the year ended May 31, 2001
and 109,861 shares for the year ended May 31, 2002.
(f) In fiscal 2001, the Company changed its estimate of useful lives for
rental inventory. The effect of this change was recorded as other
expense under Canadian GAAP. Under US GAAP, this effect would be
recorded as cost of sales. The effect of this change would be to
increase cost of sales and decrease gross margin by $2,255,867.
STOCK AND WARRANT COMPENSATION
The Company applies APB Opinion No. 25 and related interpretations in accounting
for options and warrants issued to employees. Accordingly, no compensation cost
has been recognized for issuances of options and warrants to employees at
exercise prices not less than the market value of the Company's common stock on
the grant dates. Had compensation cost for the Company's plans been determined
consistent with SFAS No. 123, the Company's net loss and loss per share would
have been increased to the pro forma amounts indicated below:
May 31,
--------------------------------------------------
2002 2001 2000
-------------- ------------- ---------------
Net income (loss)
As reported $ (522,211) $ (4,495,956) $ (827,410)
Pro forma (1,724,920) (4,614,131) (1,246,448)
Primary earnings per share
As reported $ (.04) $ (.42) $ (.09)
Pro forma (.12) (.43) (.11)
The fair value of each grant was determined using the Black-Scholes option
pricing model with the following assumptions:
May 31,
--------------------------------------------------
2002 2001 2000
-------------- ------------- ---------------
Risk-free interest rate 3.00% 5.75% 5.75%
Expected life of award 5 yrs 5 yrs 5 yrs
Dividend yield 0% 0% 0%
Volatility 135% 147% 150%
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STOCK OPTION PLANS
The Company approved a stock option plan (the "Plan") to provide directors,
officers and other key employees options to purchase shares of the Company's
stock. The Plan was approved by the Board of Directors on November 15, 2001.
Under the terms of the Plan, the Directors may grant directors, officers,
employees, and other "optionees" options with the maximum shares not to exceed
2,352,000 shares. The purchase price of the shares subject to an option will be
the market value of the Company's common stock on the date the option is
granted. Option vesting is determined upon each issuance.
A summary of the status of the Company's stock option plan as of May 31, 2002,
2001 and 2000 and changes during the years ended on those dates is presented
below:
Outstanding Options
--------------------------------------
Weighted Average
Shares Exercise Price
-------------- ----------------
FIXED OPTIONS
Balance at June 1, 1999 200,000 $ 0.20
Granted 850,000 1.51
Cancelled (200,000) 0.20
---------
Balance at May 31, 2000 850,000 $ 1.51
Granted 139,800 2.68
Balance at May 31, 2001 989,800 1.66
Granted 1,017,500 1.90
Balance at May 31, 2002 2,007,300 $ 1.78
----------- ---------
Options exercisable at year-end 1,482,062
===========
The weighted average fair value of options granted during the years ended May
31, 2000, 2001, and 2000 was $1.90, $2.68, and $1.51, respectively.
The following table summarizes information about fixed stock options outstanding
at May 31, 2002:
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Number Weighted Average Weighted
Range of Outstanding at Remaining Weighted Average Number Average
Exercise Prices May 31, 2002 Contractual Life Exercise Price Exercisable 2002 Exercise Price
$ 1.51 850,000 2.6 $ 1.51 850,000 $ 1.51
1.80 767,500 4.5 1.80 468,750 1.80
2.20 200,000 4.3 2.20 50,000 2.20
2.30 50,000 4.3 2.30 4,167 2.30
2.68 139,800 3.3 2.68 55,476 2.68
------------ ---------------- ---------------
$1.51 to $2.68 2,007,300 4.09 1,428,393 $ 1.67
============ ================ ================
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STOCK WARRANTS
A summary of the status of the Company's warrants as of May 31, 2002, 2001, and
2000 and changes during the years ended on those dates is presented below:
Weighted
Average
Shares Exercise Price
---------------- ----------------
WARRANTS
Balance at June 1, 1999 - $ -
Granted 50,000 2.00
----------------
Balance at May 31, 2000 50,000 2.00
Granted 366,733 5.00
----------------
Balance at May 31, 2001 416,733 4.64
Granted 614,018 2.09
----------------
Balance at May 31, 2002 1,030,751 $ 3.12
================ ================
Warrants exercisable at year-end 1,030,751
================
The weighted average fair value of warrants granted during the years ended May
31, 2001, 2000 and 1999 were $2.09, $5.00, and $2.00.
The following table summarizes information about warrants outstanding and
exercisable at May 31, 2002:
Weighted Average
Range of Number Outstanding at Remaining Contractual Weighted Average
Exercise Prices May 31, 2001 Life Exercise Price
- ----------------- --------------------- --------------------- ---------------------
$ 2.00 549,168 1.5 $ 2.00
2.50 114,850 2.0 2.50
5.00 366,733 3.07 5.00
--------------------- ---------------------
$2.00 to $5.00 1,030,751 2.11 $ 2.64
===================== =====================
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