UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q (Mark One) [X] Quarterly report under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended October 31, 2004 [ ] 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 1-13437 SOURCE INTERLINK COMPANIES, INC. (Exact Name of Registrant as Specified in Its Charter) MISSOURI 43-1710906 ------------------------------- ------------------- (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 27500 RIVERVIEW CENTER BLVD., SUITE 400 BONITA SPRINGS, FLORIDA 34134 - --------------------------------------- ------------------ (Address of Principal Executive Offices) (Zip Code) (239) 949-4450 ---------------------------------------------------- (Registrant's Telephone Number, Including Area Code) ---------------------------------------------------- (Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report) 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 [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date. Class Outstanding on December 9, 2004 - ---------------------------- -------------------------------- Common Stock, $.01 Par Value 23,735,173 SOURCE INTERLINK COMPANIES, INC. INDEX Page ---- PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS Consolidated Balance Sheets as of October 31, 2004 and January 31, 2004 1 Consolidated Statements of Income for the three months and nine months ended October 31, 2004 and 2003 3 Consolidated Statement of Stockholders' Equity for the nine months ended October 31, 2004 4 Consolidated Statements of Cash Flows for the nine months ended October 31, 2004 and 2003 5 Notes to Consolidated Financial Statements 6-12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 13 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK 27 ITEM 4. CONTROLS AND PROCEDURES 28 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS 29 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 29 ITEM 3. DEFAULTS UPON SENIOR SECURITIES 29 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 29 ITEM 5. OTHER INFORMATION 29 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 29 SOURCE INTERLINK COMPANIES, INC. CONSOLIDATED BALANCE SHEETS (in thousands) (unaudited) October 31, January 31, 2004 2004 ASSETS CURRENT Cash $ 1,584 $ 4,963 Trade receivables 65,737 41,834 Purchased claims receivable 3,324 5,958 Inventories 14,114 17,241 Income taxes receivable 1,049 2,067 Deferred tax asset 3,405 2,915 Advances under magazine export agreement 1,525 6,830 Other 4,345 2,536 --------- --------- TOTAL CURRENT ASSETS 95,083 84,344 ========= ========= Property, Plants and Equipment 35,114 29,145 Less accumulated depreciation and amortization (13,382) (10,582) --------- --------- NET PROPERTY, PLANTS AND EQUIPMENT 21,732 18,563 ========= ========= OTHER ASSETS Goodwill, net 63,087 45,307 Intangibles, net 13,179 7,931 Deferred tax asset 652 908 Other 6,652 7,048 --------- --------- TOTAL OTHER ASSETS 83,570 61,194 ========= ========= $ 200,385 $ 164,101 ========= ========= See accompanying notes to Consolidated Financial Statements 1 SOURCE INTERLINK COMPANIES, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except par value) (unaudited) October 31, January 31, 2004 2004 ----------- ---------- LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT Checks issued against future advances on revolving credit facility $ 2,951 $ 14,129 Accounts payable and accrued expenses, net of allowance for returns of $53,076 and $57,842 at October 31 and January 31, 2004 respectively 35,994 44,741 Deferred revenue 1,738 1,680 Current maturities of long-term debt 2,491 4,059 Other current liabilities 82 317 ----------- --------- TOTAL CURRENT LIABILITIES 43,256 64,926 Debt, less current maturities 31,570 31,541 Other long-term liabilities 1,901 560 ----------- --------- TOTAL LIABILITIES 76,727 97,027 ========== ========= COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY Contributed Capital: Preferred Stock, $0.01 par (2,000 shares authorized; none issued) - - Common Stock, $0.01 par (40,000 shares authorized; 23,663 and 18,991 shares issued) 237 190 Additional paid-in-capital 149,178 102,297 ----------- --------- Total contributed capital 149,415 102,487 Accumulated deficit (26,765) (35,778) Accumulated other comprehensive income: Foreign currency translation 1,575 932 ----------- --------- 124,225 67,641 Less: Treasury Stock (100 at cost) (567) (567) ----------- --------- TOTAL STOCKHOLDERS' EQUITY 123,658 67,074 ========== ========= $ 200,385 $ 164,101 ========== ========= See accompanying notes to Consolidated Financial Statements 2 SOURCE INTERLINK COMPANIES, INC. CONSOLIDATED STATEMENTS OF INCOME (unaudited) (in thousands, except per share data) Three Months Ended Oct. 31, Nine Months Ended Oct. 31, 2004 2003 2004 2003 ---------- ---------- --------- ---------- Revenues $ 96,045 $ 92,229 $ 273,175 $ 258,687 Costs of Revenues 69,621 67,291 199,822 189,986 ---------- ---------- --------- ---------- Gross Profit 26,424 24,938 73,353 68,701 Selling, General and Administrative Expense 14,135 13,028 40,874 39,763 Fulfillment Freight 5,611 4,516 15,244 12,995 Relocation Expenses - - 1,552 1,730 ---------- ---------- --------- ---------- Operating Income 6,678 7,394 15,683 14,213 ---------- ---------- --------- ---------- Other Income (Expense) Write off of deferred financing costs and original issue discount - (865) (1,494) (865) Interest expense (442) (844) (1,319) (2,915) Interest income 34 69 140 230 Other 140 37 207 168 ---------- ---------- --------- ---------- Total Other Income (Expense) (268) (1,603) (2,466) (3,382) ---------- ---------- --------- ---------- Income Before Income Taxes 6,410 5,791 13,217 10,831 Income Tax Expense 2,032 1,695 4,204 3,115 ---------- ---------- --------- ---------- Net Income $ 4,378 $ 4,096 $ 9,013 $ 7,716 ========== ========== ========= ========== Earnings per Share - Basic $ 0.19 $ 0.22 $ 0.40 $ 0.42 Earnings per Share - Diluted 0.18 0.20 0.37 0.40 Weighted Average of Shares Outstanding - Basic 23,374 18,544 22,727 18,378 Weighted Average of Shares Outstanding - Diluted 24,924 20,285 24,606 19,487 ========== ========== ========= ========== See accompanying notes to Consolidated Financial Statements 3 SOURCE INTERLINK COMPANIES, INC. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (unaudited) (in thousands) Other Common Stock Additional Comprehensive Treasury Stock Total ----------------- Paid - in Accumulated Income ----------------- Stockholders' Shares Amount Capital Deficit (Loss) Shares Amount Equity ------- -------- ----------- ----------- ------------- ------ -------- ------------- Balance, January 31, 2004 18,991 $ 190 $ 102,297 $ (35,778) $ 932 (100) $ (567) $ 67,074 Net income - - - 9,013 - - - 9,013 Foreign currency translation - - - - 643 - - 643 ---------- Comprehensive income 9,656 ---------- Sale of stock, $11.50 per share (net of offering costs of $3,226) 3,800 38 40,436 40,474 Exercise of stock options 872 9 4,929 - - - - 4,938 Tax benefit of stock options exercised - - 1,516 - - 1,516 ------ -------- ---------- --------- ------------ ---- ------- ---------- Balance, October 31, 2004 23,663 $ 237 $ 149,178 $ (26,765) $ 1,575 (100) $ (567) $ 123,658 ====== ======== ========== ========= ============ ==== ======= ========== See accompanying notes to Consolidated Financial Statements 4 SOURCE INTERLINK COMPANIES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (in thousands) Nine months ended October 31, 2004 2003 - ----------------------------- ------------ ----------- OPERATING ACTIVITIES Net income $ 9,013 $ 7,716 Adjustments to reconcile net income to net cash used in operating activities: Depreciation and amortization 4,018 3,046 Provision for losses on accounts receivable 593 1,588 Write off of deferred financing costs and original issue discount 1,494 865 Deferred income taxes (234) (2,084) Other 266 514 Changes in assets and liabilities (excluding business acquisitions): Increase in accounts receivable (24,751) (20,555) Decrease in inventories 3,364 67 Decrease in other assets 622 178 (Decrease) increase in accounts payable and accrued expenses (14,254) 11,261 ------------ ----------- CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES (19,869) 2,596 ------------ ----------- INVESTMENT ACTIVITIES Capital expenditures (4,069) (1,434) Purchase of claims (66,592) (51,347) Payments received on purchased claims 69,227 56,665 Acquisition of claim filing contracts (12,915) - Acquisition of net assets of wholesale magazine distributor (3,342) - Collections (advances) under magazine export agreement 5,306 (4,677) Payments under import agreement (1,500) (1,000) Payments under magazine export agreement - (1,400) Other (401) - ------------ ----------- CASH USED IN INVESTING ACTIVITIES (14,286) (3,193) ------------ ----------- FINANCING ACTIVITIES Decrease in checks issued against revolving credit facilities (11,178) (5,528) Borrowings (Repayments) under credit facilities 8,961 (15,667) Proceeds from the issuance of notes payable 10,000 20,000 Payments of notes payable (22,419) (670) Proceeds from the issuance of common stock 45,412 1,869 ------------ ----------- CASH PROVIDED BY FINANCING ACTIVITIES 30,776 4 ------------ ----------- DECREASE IN CASH (3,379) (593) CASH, beginning of period 4,963 5,570 ------------ ----------- CASH, end of period $ 1,584 $ 4,977 ============ =========== 5 1. BASIS OF PRESENTATION The consolidated financial statements included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, all adjustments (consisting of normal recurring adjustments and reclassifications) necessary to present fairly the financial position at October 31, 2004, and the results of operations and cash flows for the three months and nine months ended October 31, 2004 and 2003, have been included. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. We suggest that these consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Form 10-K for the year ended January 31, 2004. The results of operations for such interim periods are not necessarily indicative of the operating results to be expected for the full year. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Certain prior year amounts have been reclassified to conform to the current year presentation. 2. ACQUISITION AND BUSINESS COMBINATIONS Magazine Import Agreement In May, 2002, the Company entered into an agreement giving the Company the right to distribute domestically a group of foreign magazine titles. The agreement calls for an initial payment of $2.0 million, $1.0 million in fiscal 2004 and additional contingent payments up to $2.5 million spread over the two years ended May 2005 based on the overall gross profit generated from the sale of these titles. Guaranteed payments and earned contingent payments under this agreement are included in intangible assets and are being amortized over ten years, the term of the agreement (See Note 12). Magazine Export Agreement In March, 2003, the Company entered into an agreement giving the Company the right to distribute internationally a group of domestic magazine titles. The agreement calls for an initial payment of $1.4 million, guaranteed payments totaling $4.2 million spread over the next four fiscal years, and additional contingent payments up to $5.6 million based on the overall gross profit generated from the Company's international sales of these titles. Guaranteed payments under this agreement were capitalized at inception and are included in intangible assets and are being amortized over fifteen years, the term of the agreement. The remaining guaranteed balances due under the agreement are included in Debt. Under the agreement, the Company agreed to pay the prior owner's outstanding trade payables out of the collections of the prior owner's outstanding receivables. Amounts collected in excess of payments made or payments in excess of collection are to be settled at a future date. At October 31, 2004 payments in excess of collections amounted to approximately $1.5 million (See Note 12). PROMAG Retail Services, LLC Acquisition In August 2004, the Company acquired all customer based intangibles (i.e., all market composition, market share and other value) of the claiming and information services of PROMAG Retail Services, LLC ("Promag") for approximately $13.2 million. Of the $13.2 million purchase price, $10.0 million was funded from the term loan described in footnote 5 and $0.75 million in a promissory note payable over a three year period to Promag. Promag provides claim filing services related to rebates owed retailers from publishers or their designated agent throughout the United States and Canada. Goodwill and other intangible assets recorded in connection with the transaction totaled $13.2 million. The intangible assets are subject to amortization and consist primarily of customer contracts and non-compete agreements that are amortized on a straight-line basis over a weighted-average useful life of 12.77 years. Pro forma results have not been shown due to the insignificance of the acquisition. Goodwill and other intangible assets at the date of acquisition of Promag are based on a preliminary independent valuation study, therefore reported amounts may change based on finalization which is expected to occur during the fourth quarter of 2005. 6 Empire State News Corp. Acquisition In September 2004, the Company acquired substantially all of the operating assets and liabilities of Empire State News Corp. ("Empire"), a magazine wholesaler in northwest New York State for approximately $5.0 million. The purchase price consisted of $3.3 million of cash paid and $1.6 million of deferred consideration in the form of two notes payable (see footnote 4) and deferred compensation, subject to finalization of working capital adjustments in accordance with the purchase agreement. The results of Empire's operations have been included in our consolidated statements of income since September 26, 2004. The total cost of the acquisition was allocated to the assets acquired and liabilities assumed based on their respective preliminary fair values in accordance with FAS 141, Business Combinations ("FAS 141"). Goodwill recorded in connection with the transaction totaled $8.7 million. Pro forma results have not been shown due to the insignificance of the acquisition. Estimated fair values of assets acquired and liabilities assumed at the date of acquisition of Empire News are based on preliminary independent appraisals and valuation studies, therefore reported amounts may change based on finalization which is expected to occur during the fourth quarter of 2005. 3. TRADE RECEIVABLES Trade receivables consist of the following (in thousands): October 31, 2004 January 31, 2004 ---------------- ---------------- Accounts Receivable $ 133,629 $ 112,504 Allowance: Sales returns and other 63,765 66,102 Doubtful accounts 4,127 4,568 ------------ ---------- 67,892 70,670 ------------ ---------- $ 65,737 $ 41,834 ============ ========== 4. INVENTORIES Inventories consist of the following (in thousands): October 31, 2004 January 31, 2004 ---------------- ---------------- Raw materials $ 2,250 $ 2,278 Work-in-process 1,789 1,973 Finished goods: Fixtures 1,146 761 Magazine inventory 8,929 12,229 ----------- ---------- $ 14,114 $ 17,241 =========== ========== In the event of non-sale, magazine inventories are generally returnable to the publishers for full credit. 7 5. DEBT AND REVOLVING CREDIT FACILITY Debt consists of (in thousands): October 31, January 31, 2004 2004 ----------- ----------- Revolving Credit facility - Wells Fargo Foothill $ 20,695 $ 11,735 Note payable - Wells Fargo Foothill 9,750 4,083 Note payable - Hilco Capital, net of original issuance discount - 14,142 Guaranteed payments under magazine export agreement (Note 2) 2,163 3,850 Notes payable to former owners of acquired company - 1,613 Notes payable to former owners of Empire 1,200 - Other 253 177 ----------- ----------- Debt 34,061 35,600 Less current maturities 2,491 4,059 ----------- ----------- Debt, less current maturities $ 31,570 $ 31,541 =========== =========== Wells Fargo Foothill Credit Facility On October 30, 2003, the Company entered into a credit agreement with Wells Fargo Foothill. The credit agreement enables the Company to borrow up to $45.0 million under a revolving credit facility and provided a $5.0 million term note payable. The credit agreement is secured by all of the assets of the Company. In August 2004, the Company amended the credit facility with Wells Fargo Foothill. The amended facility now extends through October 31, 2009 and provides for a $10 million term note payable that bears interest at the prime rate plus 2.0% (6.75% at October 31, 2004). In addition, the Company reduced the $45.0 million revolving credit facility to $40.0 million; however the total credit facility remains $50.0 million. The term note is payable over five years with initial quarterly installments of $0.25 million payable over four quarters beginning October 31, 2004. The quarterly installments increase to $0.35, $0.50, $0.65 and $0.75 million, respectively, over the subsequent four years. Borrowings under the revolving credit facility bear interest at a rate equal to the prime rate (4.75% at October 31, 2004) plus a margin up to 0.5% (the applicable margin was 0.0% at October 31, 2004) based on an availability calculation and carries a facility fee of 1/4% per annum on the difference between $40 million and the average principal amount outstanding under the facility including advances under the revolving credit facility and letter of credits. The original $5.0 million term note payable bore interest at a rate equal to the prime rate plus 2.5%. The note was payable in equal principal installments of $0.1 million per month plus current interest. The balance on the note payable was paid in full during the quarter ended April 30, 2004. Under the credit agreement, the Company is limited in its ability to declare dividends or other distributions on capital stock or make payments in connection with the purchase, redemption, retirement or acquisition of capital stock. There are also limitations on capital expenditures and the Company is required to maintain certain financial ratios. At October 31, 2004, the impact of relocating and consolidating certain distribution fulfillment centers resulted in non-compliance with the Company's capital expenditure covenant. The Company received a permanent waiver from its lender with respect to this non-compliance and an amendment, which changed the financial covenant through January 31, 2005. Management anticipates the Company being in compliance with the amended covenant prospectively. Availability under the facility is limited by the Company's borrowing base calculation, as defined in the agreement. The calculation resulted in unused availability, after consideration of outstanding letters of credit, of $11.4 million at October 31, 2004. Hilco Capital Note Payable 8 On October 30, 2003, the Company entered into a credit agreement with Hilco Capital. The note bore a value at maturity of $15.0 million and was recorded net of the original issuance discount. Upon the closing of the agreement, Hilco received a five year warrant to purchase up to 400,000 shares of the Company's common stock at $8.04 per share. The warrants were valued at $.9 million using a Black Scholes option pricing model. The value of these warrants was recorded as an original issuance discount to the term loan and was to be amortized over the term of the loan using the effective interest method. All but a nominal amount of the term loan was paid during the quarter ended April 30, 2004 and the balance was paid in full during the quarter ended October 31, 2004. In conjunction with the prepayment of notes payable, the remaining original issue discount of approximately $0.86 million and $0.64 million of deferred financing costs were written off. Notes Payable to Former Owners of Acquired Companies In connection with the acquisition of the assets of Empire, the Company issued notes payable totaling $1,200,000 to Empire and one of the former owners of Empire. The notes payable bear interest at the lowest rate per annum allowable under the Internal Revenue Service Code Section 1274, which was 2.35% as of October 31, 2004 and are payable ratably over four fiscal years beginning with the quarter ending January 31, 2005. In connection with the acquisition of Interlink, the Company assumed debt to the former owners of International Periodical Distributors, Inc. ("IPD"). Previously, the Company was disputing the remaining amounts owed and commenced legal action requesting the court release the Company of any further obligation under these arrangements. The notes were due in fiscal 2003 and bore interest of 12%, which the Company continued to accrue pending the outcome of the litigation. In March 2004, the Company and the former owners settled the notes payable, interest accrued thereon, and the indemnification claim by the Company paying a total of $1.6 million. The aggregate amount of debt maturing in each of the next five fiscal years is as follows (in thousands): Amount -------- 2005 $ 1,279 2006 3,067 2007 2,248 2008 2,466 2009 2,805 Thereafter 22,196 -------- $ 34,061 ======== 6. SHAREHOLDERS' EQUITY In March 2004, the Company completed the sale of 3.8 million shares of common stock at $11.50 per share, excluding underwriting discounts and expenses. Net proceeds to the Company of approximately $40.5 million, after costs of issuance of $3.2 million, were utilized to repay the Wells Fargo Foothill note payable and revolving credit facility and all but a nominal amount on the Hilco Capital note payable in March 2004. 7. EARNINGS PER SHARE A reconciliation of the denominators of the basic and diluted earnings per share computations are as follows (in thousands): Three Months Ended Nine Months Ended October 31, October 31, 2004 2003 2004 2003 ------ ------ ------ ------ Basic weighted average number of common shares outstanding 23,374 18,544 22,727 18,378 Effect of dilutive securities: Stock options and warrants 1,550 1,741 1,879 1,109 ------ ------ ------ ------ Diluted weighted average number of common shares outstanding 24,924 20,285 24,606 19,487 ====== ====== ====== ====== 9 For the quarter ended October 31, 2004, stock options to purchase 524 shares were excluded from the calculation of diluted income per share because their exercise/conversion price exceeded the average market price of the common shares during the period. All warrants convertible into shares were included in the calculation above as their conversion price was less than the average market price of the common shares during the period. 8. SUPPLEMENTAL CASH FLOW INFORMATION Supplemental information on interest and income taxes paid is as follows (in thousands): Nine Months Ended October 31, 2004 2003 - ----------------------------- ----------- ----- Interest $ 1,334 2,524 Income Taxes $ 1,101 (875) =========== ===== 9. STOCK OPTION PLANS FAS No. 123, "Accounting for Stock-Based Compensation" defined a fair value method of accounting for stock options and other equity instruments. Under the fair value method, compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period, which is usually the vesting period. As provided in FAS No. 123, the Company elected to apply Accounting Principles Board ("APB") Opinion No. 25 and related interpretations in accounting for its stock-based compensation plans. The following is a reconciliation of net income per weighted average share had the Company adopted FAS No. 123 (table in thousands except per share amounts): Three Months Ended Nine Months Ended October 31, October 31, 2004 2003 2004 2003 -------- --------- -------- -------- Net income $ 4,378 $ 4,096 $ 9,013 $ 7,716 Stock compensation costs, net of tax (89) (320) (267) (960) -------- --------- -------- -------- Adjusted net income $ 4,289 $ 3,776 $ 8,746 $ 6,756 -------- --------- -------- -------- Weighted average shares, basic 23,374 18,544 22,727 18,378 Weighted average shares, diluted 24,924 20,285 24,606 19,487 Basic earnings per share - as reported $ 0.19 $ 0.22 $ 0.40 $ 0.42 Diluted earnings per share - as reported $ 0.18 $ 0.20 $ 0.37 $ 0.40 Basic earnings per share - pro-forma $ 0.18 $ 0.21 $ 0.38 $ 0.37 Diluted earnings per share - pro-forma $ 0.17 $ 0.19 $ 0.36 $ 0.35 ======== ========= ======== ======== The fair value of each option grant is estimated on the grant date using the Black-Scholes option pricing model with the following assumptions: January 31, 2004 2003 - ----------------------- ---------- ---- Dividend yield 0% 0% Expected volatility 0.50 0.50 Risk-free interest rate 2.18-2.25% 2.16% ========= ==== 10 10. SEGMENT FINANCIAL INFORMATION The Company's segment reporting is based on the reporting of senior management to the Chief Executive Officer. This reporting combines the Company's business units in a logical way that identifies business concentrations and synergies. The reportable segments of the Company are Magazine Distribution, In-Store Services, Wood Manufacturing and Shared Services. The accounting policies of the segments are materially the same as those described in the Summary of Accounting Policies. The Magazine Fulfillment segment derives revenues from (1) selling and distributing magazines, including domestic and foreign titles, to major specialty retailers and wholesalers throughout the United States and Canada, (2) exporting domestic titles internationally to foreign wholesalers or through domestic brokers, (3) serving as a secondary national distributor, (4) providing return processing services for major specialty retail book chains and (5) serving as an outsourced fulfillment agent. The In-Store Services segment derives revenues from (1) designing, manufacturing, and invoicing participants in front-end fixture programs, (2) providing claim filing services related to rebates owed retailers from publishers or their designated agent, (3) shipping, installation and removal of front-end fixtures, and (4) providing information and management services relating to retail magazine sales to U.S. and Canadian retailers and magazine publishers. The Wood Manufacturing segment derives revenues from designing, manufacturing and installing high-end wood store fixtures. Shared Services consists of overhead functions not allocated to individual operating segments. Segment results follow (in thousands): Magazine In-Store Wood Other Three Months Ended October 31, 2004 Distribution Services Manufacturing (Shared Services) Consolidated - ----------------------------------- ------------ -------- ------------- ----------------- ------------ Revenue $ 75,226 $ 14,021 $ 6,798 $ - $ 96,045 Cost of Revenue 56,125 7,970 5,526 - 69,621 --------- -------- ------- -------- --------- Gross Profit 19,101 6,051 1,272 - 26,424 Selling, General & Administrative 7,655 2,152 310 4,018 14,135 Freight Distribution 5,611 - - - 5,611 --------- -------- ------- -------- --------- Operating Income $ 5,835 $ 3,899 962 $(4,018) $ 6,678 ========= ======== ======= ======== ========= Total Assets $ 68,823 $ 93,074 $17,760 $ 20,728 $ 200,385 ========= ======== ======= ======== ========= Magazine In-Store Wood Other Nine Months Ended October 31, 2004 Distribution Services Manufacturing (Shared Services) Consolidated - ---------------------------------- ------------ -------- ------------- ----------------- ------------ Revenue $ 214,723 $ 40,003 $18,449 $ - $273,175 Cost of Revenue 162,646 22,260 14,916 - 199,822 ------------ -------- ------- ---------- -------- Gross Profit 52,077 17,743 3,533 - 73,353 Selling, General & Administrative 22,264 6,052 925 11,633 40,874 Freight Distribution 15,244 - - - 15,244 Relocation Expense 1,552 - - - 1,552 ------------ -------- ------- ---------- -------- Operating Income $ 13,017 $ 11,691 $ 2,608 $ (11,633) $ 15,683 ============ ======== ======= ========== ======== 11 Magazine In-Store Wood Other Three Months Ended October 31, 2003 Distribution Services Manufacturing (Shared Services) Consolidated - ----------------------------------- ------------ -------- ------------- ----------------- ------------ Revenue $ 68,068 $ 17,417 $ 6,744 $ - $ 92,229 Cost of Revenue 52,008 9,522 5,761 - 67,291 -------- -------- -------- --------- --------- Gross Profit 16,060 7,895 983 - 24,938 Selling, General & Administrative 7,026 2,061 322 3,619 13,028 Freight Distribution 4,516 - - - 4,516 -------- -------- -------- --------- --------- Operating Income $ 4,518 $ 5,834 661 $ (3,619) $ 7,394 ======== ======== ======== ========= ========= Total Assets 52,707 $ 83,722 $ 17,439 $ 27,715 $ 181,583 ======== ======== ======== ========= ========= Magazine In-Store Wood Other Nine Months Ended October 31, 2003 Distribution Services Manufacturing (Shared Services) Consolidated - ---------------------------------- ------------ -------- ------------- ----------------- ------------ Revenue $ 197,719 $ 46,353 $14,615 $ - $258,687 Cost of Revenue 151,268 26,110 12,608 - 189,986 --------- -------- ------- --------- -------- Gross Profit 46,451 20,243 2,007 - 68,701 Selling, General & Administrative 21,384 6,404 1,074 10,901 39,763 Freight Distribution 12,995 - - - 12,995 Relocation Expense 1,654 - - 76 1,730 --------- -------- ------- --------- -------- Operating Income $ 10,418 $ 13,839 933 $ (10,977) $ 14,213 ========= ======== ======= ========= ======== 12. SUBSEQUENT EVENTS Alliance Entertainment Corp. Acquisition On November 18, 2004, Source Interlink Companies, Inc. ("Source"), Alliance Entertainment Corp. ("Alliance") and Alligator Acquisition, LLC ("Merger Sub") entered into an Agreement and Plan of Merger (the "Merger Agreement"). Concurrently, and in connection therewith, (i) Source and Alliance entered into identical voting agreements (the "Source Voting Agreements") with each of certain directors and officers of Source and (ii) Source, Alliance and AEC Associates, LLC (the "Principal Alliance Stockholder") entered into a voting agreement (the "Alliance Voting Agreement"). Source will issue to Alliance equityholders a number of shares of its common stock (including shares reserved for issuance pursuant to outstanding options, warrants and other rights assumed by Source) equal to Source's common stock outstanding prior to the closing of the merger (including those shares issuable for outstanding options, warrants and other rights). In addition, all outstanding Alliance stock options, warrants and other rights would be assumed by Source. As a condition to the merger, all shares of the preferred stock of Alliance would be converted into shares of the common stock of Alliance. The equityholders of Alliance and the equityholders of Source will each hold 50% of the fully diluted capitalization of the combined company at the closing. Source and Alliance have agreed that, immediately after the completion of the merger, the board of directors of Source will consist of eleven directors, including (i) six members designated by Source, three of whom will be independent, and (ii) five members designated by Alliance, three of whom will be independent. Source and Alliance have made customary representations, warranties and covenants in the Merger Agreement, including, among others, covenants (i) not to (A) solicit proposals relating to alternative business combination transactions or (B) subject to certain exceptions, enter into discussions concerning or provide confidential information in connection with alternative business combination transactions, (ii) to cause stockholder meetings to be held to consider approval of the merger and related transactions, and (iii) subject to certain exceptions, for their respective boards of directors to recommend adoption and approval by its stockholders of the Merger Agreement and related transactions. Consummation of the merger is subject to various conditions, including, among other things, the approval by the stockholders of Source and Alliance, no legal impediment to the merger, the receipt of required regulatory approvals, receipt of existing lender consent and completion of a distribution by Alliance of its assets related to its "All Media Guide" and Digital On- 12 Demand" businesses. The Merger Agreement contains certain termination rights for both Source and Alliance, and further provides that, upon termination of the Merger Agreement under specified circumstances Source may be required to pay Alliance a termination fee of $5 million. Sale of Secondary Wholesale Distribution Operations In November 2004, the Company sold its secondary wholesale distribution operations and received net sales proceeds of approximately $1.4 million. The sale of the business is not expected to result in a gain or loss for financial reporting purposes. Magazine Import and Export Acquisition Worldwide purchases In November 2004, the Company entered into an agreement to terminate leases under the magazine import and the magazine export agreements and acquire all import and export assets, naming rights and other intangibles including a non-compete by the seller. The purchase price of the import and export businesses (after an allowed reduction of the purchase price for payments made by the Company under the prior lease agreements) was approximately $14.1 million. The purchase price was comprised of $4.2 million paid in cash on the last business day of November 2004 and notes payable in the amount of $9.9 million, payable over 13 quarters in equal installments of $0.7 million. In addition, a second note payable in the amount of $0.99 million is payable in full on May 1, 2005. Since the Company has historically operated these magazine import and export businesses under leases, results of operations for the import and export businesses are included in the statement of operations for the nine month periods ended October 31, 2004 and 2003, respectively. 13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. A CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS Some of the information in this report contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be preceded by, followed by or include the words "believe," "expect," "anticipate,' "estimate," "project," or similar expressions. Other statements in this report that are not historical facts are "forward-looking statements" for the purpose of the safe harbor provided by Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. These statements may include, but are not limited to, projections of collections, revenues, income or loss, estimates of capital expenditures, plans for future operations, products or services, and financing needs or plans, as well as assumptions relating to these matters and other possible or future actions. These statements involve estimates, assumptions and predictions made by our management and you should not unduly rely on them. Our actual results will differ, perhaps materially, from those anticipated in these forward-looking statements as a result of a number of factors, including the risks and uncertainties faced by us described below and elsewhere in this report: - market acceptance of and continuing demand for our services; - the impact of competitive services; - the pricing and reimbursement policies of magazine publishers; - our ability to obtain additional financing to support our operations; - changing market conditions; - demand for magazines at the retailers we service; and - our ability to access retailers' point-of-sales information needed to efficiently allocate distribution. We believe it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to predict accurately or over which we have no control. The factors listed above provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. Before you make an investment decision relating to our common stock, you should be aware that the occurrence of the events described in these risk factors could have a material adverse effect on our business, operating results and financial condition. You should read and interpret any forward-looking statement in conjunction with our consolidated financial statements, the notes to our consolidated financial statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations." Any forward-looking statement speaks only as of the date on which that statement is made. Unless required by U.S. federal securities laws, we will not update any forward-looking statement to reflect events or circumstances that occur after the date on which the statement is made. Our business consists of four business segments: Magazine Fulfillment, In-Store Services, Wood Manufacturing and Shared Services. Our segment reporting is structured based on the reporting of senior management to the Chief Executive Officer. - Our Magazine Fulfillment group provides domestic and foreign titled magazines to specialty retailers, such as bookstores and music stores, and to mainstream retailers, such as supermarkets, discount stores, drug stores, convenience stores and newsstands. This group also exports domestic titled magazines from more than 100 publishers to foreign markets worldwide. We provide fulfillment services to more than 23,000 retail stores, 7,000 of which also benefit from our selection and logistical procurement services. - Our In-Store Services group assists retailers with the design and implementation of their front-end area merchandise programs, which generally have a three-year life cycle. We also provide other value-added services to retailers, publishers and other vendors. These services include assisting retailers with the filing of claims for publisher incentive payments, which are based on display location or total retail sales, and providing publishers with access to real-time sales information on more than 10,000 magazine titles, thereby enabling them to make more informed decisions regarding their product placement, cover treatments and distribution efforts. - Our Wood Manufacturing group designs and manufactures wood display and store fixtures for leading specialty retailers. 14 - Our Shared Services group consists of overhead functions not allocated to the other groups. These functions include corporate finance, human resource, management information systems and executive management that are not allocated to the three operating groups. Upon completion of our consolidation of our administrative operations, we restructured our accounts to separately identify corporate expenses that are not attributable to any of our three main operating groups. Prior to fiscal year 2004, these expenses were included within our In-Store Services group. REVENUES The Magazine Fulfillment group derives revenues from: - selling and distributing magazines, including domestic and foreign titles, to specialty and mainstream retailers throughout the United States and Canada, - exporting domestic titles internationally to foreign wholesalers or through domestic brokers, - serving as a secondary national distributor, - providing return processing services for major specialty retail book chains, and - serving as an outsourced fulfillment agent and backroom operator for publishers. The In-Store Services group derives revenues from: - designing, manufacturing and invoicing participants in front-end merchandising programs, - providing claim filing services related to rebates owed retailers from publishers or their designated agents, - storing, shipping, installing, and removing front-end fixtures, and - providing information and management services relating to magazine sales to retailers and publishers throughout the United States and Canada. The Wood Manufacturing group derives revenues from designing, manufacturing and installing custom wood fixtures primarily for retailers. COST OF REVENUES Our cost of revenues for the Magazine Fulfillment group consists of the costs of magazines purchased for resale less all applicable publisher discounts and rebates. Our cost of revenues for the In-Store Services and the Wood Manufacturing groups includes: - raw materials consumed in the production of display fixtures, primarily steel, wood and plastic components; - production labor; and - manufacturing overhead. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses for each of the operating groups include: - non-production labor; - rent and office overhead; - insurance; - professional fees; and - management information systems. Expenses associated with corporate finance, human resources, management information systems and executive offices are included within the Shared Services group and are not allocated to the other groups. FULFILLMENT FREIGHT Fulfillment freight consists of our direct costs of distributing magazines by third-party freight carriers, primarily Federal Express ground service. Freight rates are driven primarily by the weight of the copies being shipped and the distance between origination and destination. 15 Fulfillment freight is not disclosed as a component of cost of revenues, and, as a result, gross profit and gross profit margins are not comparable to other companies that include shipping and handling costs in cost of revenues. Fulfillment freight has increased proportionately as the amount of product we distribute has increased. We anticipate the continued growth in our Magazine Fulfillment group will result in an increase in fulfillment freight. Generally, as pounds shipped increase, the cost per pound charged by third party carriers decreases. As a result, fulfillment freight as a percent of Magazine Fulfillment group revenue should decline slightly in the future. RELOCATION EXPENSES Relocation expenses in 2003 consisted primarily of the cost of transferring existing employees and offices from their former locations in High Point, North Carolina, St. Louis, Missouri, and San Diego, California, to our new offices in Bonita Springs, Florida. In addition, during the nine months ended October 31, 2004, the Company began expansion into the mainstream retail market. The expansion schedule required an acceleration of the relocation process from the distribution fulfillment center in Milan, Ohio to Harrisburg, Pennsylvania, which was completed by April 30, 2004. RESULTS OF OPERATIONS The following table sets forth, for the periods presented, information relating to our operations (in thousands): 2004 2003 MARGIN MARGIN THREE MONTHS ENDED OCTOBER 31, AMOUNT % AMOUNT % - ------------------------------ -------- ------ ---------- ------ Magazine Fulfillment Revenue $ 75,226 $ 68,068 Cost of revenue 56,125 52,008 Gross profit 19,101 25.4% 16,060 23.6% Operating expense (1) 13,266 11,542 Operating income 5,835 7.8% 4,518 6.6% In-Store Services Revenue $ 14,021 $ 17,417 Cost of revenue 7,970 9,522 Gross profit 6,051 43.2% 7,895 45.3% Operating expense (1) 2,152 2,061 Operating income 3,899 27.8% 5,834 33.4% Wood Manufacturing Revenue $ 6,798 $ 6,744 Cost of revenue 5,526 5,761 Gross profit 1,272 18.7% 983 14.6% Operating expense (1) 310 322 Operating income 962 14.2% 661 9.8% Shared Services Revenue $ - $ - Cost of revenue - - Gross profit - - Operating expense (1) 4,018 n/a 3,619 n/a Relocation expenses - - Operating loss (4,018) n/a (3,619) n/a Total Revenue $ 96,045 $ 92,229 Cost of revenue 69,621 67,291 16 Gross profit 26,424 27.5% 24,938 27.0% Operating expense (1) 19,746 17,544 Operating income 6,678 7.0% 7,394 8.0% ====== ==== ====== ==== (1) Operating expenses include selling, general and administrative expenses, fulfillment freight and amortization of goodwill. 2004 2003 MARGIN MARGIN NINE MONTHS ENDED OCTOBER 31, AMOUNT % AMOUNT % - ----------------------------- ---------- ------ ---------- ------ Magazine Fulfillment Revenue $ 214,723 $ 197,719 Cost of revenue 162,646 151,268 Gross profit 52,077 24.3% 46,451 23.5% Operating expense (1) 37,508 34,379 Relocation expenses 1,552 1,654 Operating income 13,017 6.1% 10,418 5.3% In-Store Services Revenue $ 40,003 $ 46,353 Cost of revenue 22,260 26,110 Gross profit 17,743 44.4% 20,243 43.7% Operating expense (1) 6,052 6,404 Operating income 11,691 29.2% 13,839 29.9% Wood Manufacturing Revenue $ 18,449 $ 14,615 Cost of revenue 14,916 12,608 Gross profit 3,533 19.2% 2,007 13.7% Operating expense (1) 925 1,074 Operating income 2,608 14.1% 933 6.4% Shared Services Revenue $ - $ - Cost of revenue - - Gross profit - - Operating expense (1) 11,633 n/a 10,901 n/a Relocation expenses - 76 Operating loss (11,633) n/a (10,977) n/a Total Revenue $ 273,175 $ 258,687 Cost of revenue 199,822 189,986 Gross profit 73,353 26.9% 68,701 26.6% Operating expense (1) 56,118 52,758 Relocation expenses 1,552 1,730 Operating income 15,683 5.7% 14,213 5.5% ====== ==== ====== ==== (1) Operating expenses include selling, general and administrative expenses, fulfillment freight and amortization of goodwill. 17 REVENUES THREE MONTHS ENDED OCTOBER 31, 2004, AS COMPARED TO THE THREE MONTHS ENDED OCTOBER 31, 2003 Revenues for the quarter ended October 31, 2004 increased $3.8 million, or 4.1%, from the prior year due primarily to an increase in revenue in our Magazine Fulfillment group as described below. Magazine Fulfillment group's revenues were $75.2 million, an increase of $7.1 million or 10.5% as compared to the quarter ended October 31, 2003. The group's revenues for the three months ended October 31 are comprised of the following components (in thousands): 2004 2003 Change --------- ------- ------- Domestic distribution $ 60,690 $54,025 $ 6,665 Export distribution 8,576 9,206 (630) Secondary wholesale distribution 5,291 4,629 662 Other 1,047 613 434 Intra-segment sales (378) (405) 27 --------- ------- ------- Total $ 75,226 $68,068 $ 7,158 ========= ======= ======= Domestic distribution consists of the gross amount of magazines (both domestic and imported titles) distributed to domestic retailers and wholesalers, less actual returns received, less an estimate of future returns and customer discounts. The $6.7 million increase in domestic distribution relates primarily to a $25.2 million increase in gross distribution partially offset by an estimated higher return rate. The increase in gross distribution related both to an increase in copies distributed as well as an increase in the amount billed per copy. Gross domestic distribution to our two largest specialty retail customers increased $9.2 million. Estimated sell-through for the quarter was lowered from 48.5% to 45.4%. Revenues from our secondary wholesale operations for the quarter ended October 31, 2004 increased approximately $0.7 million due to an increase in the number of wholesale operations we serviced as compared to the quarter ended October 31, 2003. Subsequent to the period end, the Company sold its secondary wholesale distribution operations. Our In-Store Services group revenues were $14.0 million, a decrease of $3.4 million or 19.5%, for the three months ended October 31, 2004 as compared to the comparable quarter of the prior year. The group's revenues are comprised of the following components (in thousands): 2004 2003 Change ------- ------- -------- Claim filing and information $ 5,173 $ 3,106 $ 2,067 Front end wire and services 8,848 14,311 (5,463) ------- ------- -------- Total $14,021 $17,417 $ (3,396) ======= ======= ======== Our claim filing revenues are recognized at the time the claim is paid. The increase in revenues in the current period relate primarily to the timing of the cash payments received on the claims. In addition, the Company acquired Promag Retail Services, LLC in August 2004 which also contributed to the increased revenues for the quarter. Our front end wire and services revenues declined due to the cyclical nature of the industry. Major chains typically purchase new front-end fixtures every three years however, the use of the front end fixtures has been extending beyond this life cycle. In addition, there was a significant new customer in the quarter ended October 31, 2003 that did not recur in the quarter ended October 31, 2004. Our Wood Manufacturing group's revenues were $6.8 million for the three months ended October 31, 2004 as compared to $6.7 million for the comparable period of the prior year. NINE MONTHS ENDED OCTOBER 31, 2004, AS COMPARED TO THE NINE MONTHS ENDED OCTOBER 31, 2003 Revenues for the nine month period ended October 31, 2004 increased $14.5 million, or 5.6%, from the prior year due primarily to an increase in revenue in our Magazine Fulfillment and Wood Manufacturing groups as described below. 19 Magazine Fulfillment group's revenues were $214.7 million, an increase of $17.0 million or 8.5% as compared to the nine months ended October 31, 2003. The group's revenues for the nine months ended October 31 are comprised of the following components (in thousands): 2004 2003 Change -------- -------- ------- Domestic distribution $170,805 $158,793 $12,012 Export distribution 28,731 24,947 3,784 Secondary wholesale distribution 13,380 12,913 467 Other 2,805 2,152 653 Intra-segment sales (998) (1,086) 88 -------- -------- ------- Total $214,723 $197,719 $17,004 ======== ======== ======= Domestic distribution consists of the gross amount of magazines (both domestic and imported titles) distributed to domestic retailers and wholesalers, less actual returns received, less an estimate of future returns and customer discounts. The $12.0 million increase in domestic distribution relates primarily to a $49.2 million increase in gross distribution partially offset by an estimated higher return rate. The increase in gross distribution related both to an increase in copies distributed as well as an increase in the amount billed per copy. Gross domestic distribution to our two largest customers increased $30.8 million. Estimated sell-through for the period was lowered from 48.5% to 44.2%. Our export distribution began operation in March 2003. Export distribution increased $3.8 million for the nine month period ended October 31 over the comparable period of the prior year due primarily to an additional month of distribution in the current period. Our In-Store Services group revenues were $40.0 million, a decrease of $6.3 million or 13.7%, for the nine months ended October 31, 2004 as compared to the comparable period of the prior year. The group's revenues are comprised of the following components (in thousands): 2004 2003 Change ------- ------- -------- Claim filing and information $13,499 $ 9,874 $ 3,625 Front end wire and services 26,504 36,479 (9,975) ------- ------- -------- Total $40,003 $46,353 $ (6,350) ======= ======= ======== Our claim filing revenues are recognized at the time the claim is paid. The increase in revenues in the current period relate to the timing of the cash payments received on the claims. In addition, the Company acquired Promag Retail Services, LLC in August 2004 which also contributed to the increased revenues for the nine month period ended October 31, 2004. Our front end wire and services revenues declined due to the cyclical nature of the industry. Major chains typically purchase new front-end fixtures every three years however, the use of the front end fixtures has been extending beyond this life cycle. The Wood Manufacturing group's revenues were $18.4 million, an increase of $3.8 million or 26.2%, for the nine months ended October 31, 2004 as compared to the comparable period of the prior year. The increase for the nine month period relates to an increase in the number of store openings and remodelings performed by our customers. In addition, we added a number of significant new customers in the second quarter of the nine month period ended October 31, 2004. GROSS PROFIT THREE MONTHS ENDED OCTOBER 31, 2004, AS COMPARED TO THE THREE MONTHS ENDED OCTOBER 31, 2003 Gross profit for the three months ended October 31, 2004 increased $1.5 million or 6.0%, over the same quarter in the prior fiscal year due primarily due to an increase in sales volume in our Magazine Fulfillment group. Gross Profit in our Magazine Fulfillment group increased approximately $3.0 million or 18.9% for the quarter ended October 31, 2004 as compared to the comparable quarter of the prior year. The increase related primarily to the increased distribution revenue as described above and the improvement in gross profit margins from 23.6% to 25.4%. The gross profit margins in 20 our domestic distribution businesses are generally higher than our export distribution and secondary wholesale businesses and, as a result, overall gross profit margins improve as the portion of total revenues is weighted more toward our domestic operations. We have also been able to utilize the working capital raised through our equity offering and operating profits to improve selling and buying terms with some of our major suppliers and customers. In addition, we receive certain supplier rebates on gross distribution and as efficiency decreases those rebates become a greater portion of the overall gross profit contribution yielding higher gross profit margins. Gross profit in our In-Store Services group decreased $1.8 million or 23.4% for the three months ended October 31, 2004 as compared to the comparable quarter of the prior year. The decrease in gross profit is primarily due to a decrease in revenues of the front end wire and services as described above as the gross margin percentage remained consistent. Gross profit in our Wood Manufacturing group increased $0.3 million or 29.4% for the three months ended October 31, 2004 as compared to the comparable period of the prior year. The increase related primarily to operational efficiencies at the manufacturing facilities. NINE MONTHS ENDED OCTOBER 31, 2004, AS COMPARED TO THE NINE MONTHS ENDED OCTOBER 31, 2003 Gross profit for the nine months ended October 31, 2004 increased $4.7 million or 6.8%, over the same period in the prior fiscal year due primarily due to an increase in sales volume in our Magazine Fulfillment group and our Wood Division. The increase was partially offset by decreases in our In-Store Services group. Gross Profit in our Magazine Fulfillment group increased approximately $5.6 million or 12.1% for the nine months ended October 31, 2004 as compared to the comparable period of the prior year. The increase related primarily to the increased distribution revenue as described above and the improvement in gross profit margins from 23.5% to 24.3%. The improved gross profit amounts and margin for the nine month period are related to the same items discussed in the above analysis of the quarter. Gross profit in our In-Store Services group decreased $2.5 million or 12.3% for the nine month period ended October 31, 2004 as compared to the comparable period of the prior year. The decrease in gross profit is primarily due to a decrease in revenues as described above as the gross margin percentage remained consistent. Gross profit in our Wood Manufacturing group increased $1.5 million or 76.0% for the nine month period ended October 31, 2004 as compared to the comparable period of the prior year. The increase related to the new business discussed above. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses for the quarter ended October 31, 2004 increased $1.1 million or 8.5%, compared to the quarter ended October 31, 2003. Selling, general, and administrative expenses as a percent of revenues increased from 14.1% to 14.7%. The Magazine Fulfillment group's selling, general and administrative expenses increased $0.63 million, or 9.0% over the quarter ended October 31, 2003. As a percentage of sales, selling, general and administrative expenses have decreased from 10.3% to 10.2% compared to the prior year same period due to our ability to leverage existing infrastructure over a larger base of distribution and the consolidation of our distribution center in Milan, Ohio into Harrisburg, Pennsylvania. The selling, general, and administrative expenses of In-Store Services increased $0.09 million or 4.4%. This change is insignificant compared to the quarter ended October 31, 2003. The selling, general, and administrative expenses of Shared Services increased $0.40 million or 11.0%. The overall increase is primarily due to Sarbanes-Oxley compliance charges and increased depreciation expense due to increased capital expenditures. The Wood Manufacturing group's selling, general, and administrative expenses decreased $0.01 million or 3.7%. This change is insignificant compared to the quarter ended October 31, 2003. 21 Selling, general and administrative expenses for the nine month period ended October 31, 2004 increased $1.1 million or 2.8% compared to the nine month period ended October 31, 2003. Selling, general, and administrative expenses as a percent of revenues declined from 15.4% to 15.0%. The Magazine Fulfillment group's selling, general, and administrative expenses increased $0.88 million, or 4.1% over the nine month period ended October 31, 2003. As a percentage of sales, selling, general and administrative expenses have decreased from 10.8% to 10.4%. The increase in overall expenses and change in those expenses as related to sales are related to the same items discussed in the above analysis of the quarter. The selling, general, and administrative expenses of In-Store Services decreased $0.35 million or 5.5%. The decrease relates to a reduction in executive salary expense as compared to the nine month period ended October 31, 2003. The selling, general, and administrative expenses of Shared Services increased $0.73 million or 6.7% for the nine month period ended October 31, 2004. The overall increase is primarily due to Sarbanes-Oxley compliance charges and increased depreciation expense due to increased capital expenditures. The Wood Manufacturing group's selling, general, and administrative expenses decreased $0.15 million or 13.9% compared to the nine month period ended October 31, 2003. The decrease was attributable primarily to a head count reduction. FULFILLMENT FREIGHT Fulfillment freight represents the outbound freight costs of domestic distribution. It consists primarily of payments to third party carriers to provide delivery service from our distribution centers to our customer's retail stores. Fulfillment freight expenses increased $1.1 million or 24.2%, compared to the three months ended October 31, 2003 and $2.2 million or 17.3% compared to the nine months ended October 31, 2003. Freight expense as a percent of gross domestic distribution decreased from 4.3% to 4.1% for the quarter ended October 31, 2004 and 4.1% to 4.0% for the nine month period ended October 31, 2004. The decrease is attributable to both the consolidation of our distribution center in Milan, Ohio into Harrisburg, Pennsylvania and the decrease in cost per pound as the weight increases in our freight providers pricing schedule. RELOCATION EXPENSES During the nine months ended October 31, 2004, the Company began expansion into the mainstream retail market. The expansion schedule required an acceleration of the relocation process from the distribution fulfillment center in Milan, OH to Harrisburg, PA, which was completed by April 30, 2004. Relocation expenses recorded in the first quarter, including a lease termination charge and the transfer of employees and equipment, were approximately $1.6 million. During the nine month period ended October 31, 2003, the company relocated the magazine distribution back office from San Diego, California to Bonita Springs, Florida. The total expense recorded related to this relocation was $1.7 million. OPERATING INCOME Operating income for the quarter ended October 31, 2004 decreased $0.7 million or 9.7%, compared to the quarter ended October 31, 2003 due to the factors described above. Operating income for the nine months ended October 31, 2004 increased $1.5 million or 10.3%, compared to the nine months ended October 31, 2003 due to the factors described above Operating profit margins decreased from 8.0% for the quarter ended October 31, 2003 to 7.0% for the quarter ended October 31, 2004 and increased from 5.5% for the nine month period ended October 31, 2003 to 5.7% for the nine month period ended October 31, 2004. The increase for the nine month period was due to the improvement in our gross profit coupled with increased revenue from the Wood and Magazine Fulfillment Divisions and a decrease in our selling, general, and administrative expenses as a percent of revenues. INTEREST EXPENSE 22 Interest expense includes the interest and fees on our significant debt instruments and outstanding letters of credit. Interest expense decreased $0.4 million or 47.6% from the quarter ended October 31, 2004 and $1.6 million or 54.8% for the nine month period ended October 31, 2004. Interest expense decreased from the prior year quarter and nine month period due to significantly lower borrowings. The lower borrowing levels are due to the raising of proceeds from the sale of 3.8 million shares of common stock. OTHER INCOME (EXPENSE) Other income (expense) consists of items outside of the normal course of operations. Due to its nature, comparability between periods is not generally meaningful. For the nine month periods ended October 31, 2004 and 2003, the Company recorded charges of approximately $1.5 million and $0.86 million related to the write off of deferred financing charges as a result of paying off certain debt instruments, as described below in Liquidity and Capital Resources. INCOME TAX EXPENSE The effective income tax rates were 31.70% and 29.3% for the quarters ended October 31, 2004 and 2003, respectively. The effective income tax rates were 31.8% and 28.8% for the nine months ended October 31, 2004 and 2003, respectively. The difference between the statutory rate and effective tax rates relates primarily to the realization of a portion of the net operating loss carry-forward acquired with our acquisition of Interlink. LIQUIDITY AND CAPITAL RESOURCES OVERVIEW Our primary sources of cash include receipts from our customers and borrowings under our credit facilities and from time to time the proceeds from the sale of common stock. Our primary cash requirements for the Magazine Fulfillment group consist of the cost of magazines and the cost of freight, labor and facility expense associated with our distribution centers. Our primary cash requirements for the In-Store Services group consist of the cost of raw materials, labor, and factory overhead incurred in the production of front-end displays, the cost of labor incurred in providing our claiming, design and information services and cash advances funding our Advance Pay program. Our Advance Pay program allows retailers to accelerate collections of their rebate claims through payments from us in exchange for the transfer to us of the right to collect the claim. We then collect the claims when paid by publishers for our own account. Our primary cash requirements for the Wood Manufacturing group consist of the cost of raw materials, the cost of labor, and factory overhead incurred in the manufacturing process. Our primary cash requirements for the Shared Services group consist of salaries, professional fees and insurance not allocated to the operating groups. 23 The following table presents a summary of our significant obligations and commitments to make future payments under debt obligations and lease agreements due by fiscal year as of October 31, 2004 (in thousands). Payments Due by Period ----------------------------------------------------------------------------- Less Than 1-3 4-5 After 5 Total 1 year Years Years Years ---------- --------- ---------- --------- ---------- Debt obligations $ 34,061 $ 1,279 $ 5,315 $ 5,271 $ 22,196 Operating leases 34,108 1,289 8,132 6,499 18,188 ---------- --------- ---------- --------- ---------- Total contractual cash obligations $ 68,169 $ 2,568 $ 13,447 $ 11,770 $ 40,384 ========== ========= ========== ========= ========== The following table presents a summary of our commercial commitments and the notional amount expiration by period (in thousands): Notional amount expiration by period ----------------------------------------------------- Less Than 1-3 4-5 After 5 Total 1 year Years Years Years ------- ------ ----- ----- ------ Financial standby letters of credit $ 3,750 $3,750 $ - $ - $ - ------- ------ ----- ----- ----- Total commercial commitments $ 3,750 $3,750 $ - $ - $ - ======= ====== ===== ===== ===== OPERATING CASH FLOW Net cash used in and provided by operating activities was $19.9 and $2.6 million for the nine months ended October 31, 2004 and 2003, respectively. Operating cash flows for the nine months ended October 31, 2004 were primarily from net income ($9.0 million), plus non-cash charges including depreciation and amortization ($4.0 million) and provisions for losses on accounts receivable ($0.6 million), a write off of deferred financing costs and original issue discount ($1.5 million), a decrease in inventories ($3.4 million), a decrease in other assets ($0.6 million). These cash providing activities were offset by an increase in accounts receivable ($24.7 million) and a decrease in accounts payable and accrued expenses ($14.3 million). 24 The increase in accounts receivable for the nine months ended October 31, 2004 was primarily due to an increase in accounts receivable in our Magazine Fulfillment group. The increase was due to an overall increase in distribution levels, especially in the last month of the quarter, more lenient payment terms offered to a significant customer in exchange for more favorable pricing, and the increase in the sales return reserve from January 31, 2004. Receivables in our Wood Manufacturing division increased by approximately $2.9 million, due to additional revenues in the period of approximately $3.8 million. The In-Store Division had an increase in accounts receivable of approximately $3.4 million due primarily due to the seasonal nature of the wire manufacturing business, which generally has the highest receivable balance in the third quarter. The fourth quarter is generally our best collection and cash flow quarter of the year as revenues from the third quarter are collected. The decrease in accounts payable and accrued expenses in the current period of $14.3 million relates to 1) a decrease in the accounts payable in our Magazine Fulfillment group where we utilized available funds to pay vendors earlier in order to generate additional margin 2) a reduction in customer deposits due to change in payment terms and 3) timing of payments to vendors in the current period. Operating cash flows for the nine months ended October 31, 2003 were primarily from net income ($7.7 million), adding back non-cash charges such as depreciation and amortization ($3.0 million) and provisions for losses on accounts receivable ($1.6 million), and a significant increase in accounts payable ($11.3 million). These cash providing activities were offset by a significant increase in accounts receivable ($20.5 million). The increase in accounts receivable and accounts payable related primarily to the magazine export agreement and the inception of that business. The magazine export agreement allowed us to become a leading exporter of domestic titles to wholesalers overseas. Magazine are purchased directly from domestic publishers and sold on extended terms to foreign distribution agents who distribute the magazines to retailers in their geographic territories. The inception of this business resulted in an increase in accounts receivable and an increase in accounts payable. The first nine months of the current year includes eight months of operations from this business and only five months of cash collections due to standard payment terms of 90 days, which is typical for this segment of the industry. INVESTING CASH FLOW Net cash used in investing activities was $14.3 and $3.2 million for the nine months ended October 31, 2004 and 2003, respectively. For the nine months ended October 31, 2004, cash used in investing activities included capital expenditures of $4.1 million, which in part related to our expansion of our distribution facility in Harrisburg, Pennsylvania. Our advance pay program generated net cash flow of $2.6 million in the current period. In addition, the Company advanced to the prior operator of our export distribution business $6.8 million at January 31, 2004. The advances were made as part of the agreement to collect the prior operator's receivables and pay outstanding payables so as to create a seamless transition for both the customers and suppliers. The company collected $5.3 million of the advances during the nine months ended October 31, 2004. In August 2004, the Company acquired all customer-based intangibles (i.e., all market composition, market share and other value) of the claiming and information services of PROMAG Retail Services, LLC ("Promag") for approximately $13.2 million. Of the $13.2 million purchase price, $10.0 million was funded from a term loan discussed below and $0.75 million in a promissory note payable over a three year period to Promag. Promag provides claim filing services related to rebates owed retailers from publishers or their designated agent throughout the United States and Canada. In September 2004, the Company acquired substantially all of the assets and liabilities of Empire State News Corp. ("Empire"), a magazine wholesaler in northwest New York State for approximately $5.0 million. The purchase price consisted of $3.3 million of cash paid and $1.6 million of deferred consideration in the form of two notes payable ($1.2 million) and deferred compensation, subject to finalization of working capital adjustments in accordance with the purchase agreement. For the nine months ended October 31, 2003, cash provided by investing activities related to capital expenditures of $1.4 million, which related primarily to our relocation to Florida, and $1.4 million of payments made related to the acquisition of customer lists under the export agreement and a contingent payment of $1.0 million under the magazine import agreement. Finally, in connection with the magazine export agreement discussed in the paragraph above, the company had advanced $4.7 million during the nine months ended October 31, 2003. 25 Our borrowing agreements limit the amount of our capital expenditures in any fiscal year. FINANCING CASH FLOW Outstanding balances on our credit facility fluctuate partially due to the timing of the retailer rebate claiming process and our Advance Pay program, the seasonality of our front end wire and services business and the payment cycle of the magazine distribution business. Because the magazine distribution business and Advance Pay program cash requirements peak at our fiscal quarter ends, the reported bank debt levels usually are the maximum level outstanding during the quarter. Payments under our Advance Pay program generally occur just prior to our fiscal quarter end. The related claims are not generally collected by us until 30-60 days after the advance is made. As a result, our funding requirements peak at the time of the initial advances and decrease over this period as the cash is collected on the related claims. The front end wire and services business is seasonal because most retailers prefer initiating new programs before the holiday shopping season begins, which concentrates revenues in the second and third quarter. Receivables from these fixture programs are generally collected from all participants within 180 days. We are usually required to tender payment on the costs of these programs (raw material and labor) within a shorter period. As a result, our funding requirements peak in the second and third fiscal quarters when we manufacture the wire fixtures and decrease significantly in the fourth and first fiscal quarters as the related receivable are collected and significantly less manufacturing activity is occurring. Within our magazine distribution business, our significant customers pay weekly, and we pay our suppliers monthly. As a result, funding requirements peak at the end of the month when supplier payments are made and decrease over the course of the next month as our receivables are collected. Net cash provided by financing activities was $30.8 and $0.0 million for the nine months ended October 31, 2004 and 2003, respectively. Financing activities in the first nine months of fiscal year 2005 consisted of proceeds from the sale of 3.8 million shares of common stock. The proceeds of $40.5 million (net of underwriting and related expenses) from the sale were utilized to repay the Wells Fargo Foothill original term loan, the Hilco Capital note payable and the notes payable to former owners ($22.4 million through October 31, 2004). For the nine month period ended October 31, 2004, borrowings on the credit facilities totaled $8.9 million and a term loan in the amount of $10.0 million was issued related to the Promag transaction. In addition, the cash provided by the activities noted above were offset by an $11.1 million decrease in checks issued and outstanding at October 31, 2004. Finally, the exercise of employee stock options in the period generated approximately $4.9 million. Financing activities for the first nine months of fiscal year 2004 consisted primarily of repayments on our credit facilities ($15.7 million) and proceeds from the issuance of notes payable ($20.0 million). These borrowings were offset by a $5.5 million reduction of checks issued and outstanding at October 31, 2003. The exercise of employee stock options in the period generated approximately $1.9 million. DEBT At October 31, 2004, our total debt obligations were $34.1 million, excluding outstanding letters of credit. Debt consists primarily of our amounts owed under the Revolving Credit facility, the term loan with Wells Fargo Foothill and the magazine export agreement. On October 30, 2003, we entered into a credit agreement with Wells Fargo Foothill. The credit agreement enabled us to borrow up to $45.0 million under a revolving credit facility. The credit agreement expired on October 30, 2006 and was secured by all of the assets of the Company. In August 2004, the Company amended the credit facility with Wells Fargo Foothill. The amended facility now extends through October 31, 2009 and provides for a $10 million term note payable that bears interest at the prime rate plus 2.0% (6.75% at October 31, 2004). In addition, the Company reduced the $45.0 million revolving credit facility to $40.0 million however the total credit facility remains $50.0 million. The term note is payable over five years with initial quarterly installments of $0.25 million payable over four quarters beginning October 31, 2004. The quarterly installments increase to $0.35, $0.50, $0.65 and $0.75 million, respectively, over the subsequent four years. 26 Borrowings under the revolving credit facility bear interest at a rate equal to the prime rate (4.75% at October 31, 2004) plus up to 0.5% based on an availability calculation and carries a facility fee of 1/4% per annum on the difference between $40.0 million and the average principal amount outstanding under the facility including advances under the revolving credit facility and letters of credit. The balance on the credit facility at October 31, 2004 was $20.7 million. Availability under the revolving facility is limited by a borrowing base calculation, as defined in the agreement. The calculation resulted in excess availability of $11.4 million at October 31, 2004. On October 30, 2003, we entered into a credit agreement with Hilco Capital. The note payable had a face value of $15.0 million and was recorded net of the original issuance discount related to the fair value of warrants issued concurrently with the note. The note payable bore interest at a rate equal to the greater of the prime rate (4.75% at October 30, 2004) plus 7.75% or 12% and deferred interest of 2% due at the termination of the agreement on October 30, 2006. The term loan was paid in full during the quarter ended October 31, 2004. Under the credit agreements, we are required to maintain a specified minimum level of EBITDA and compliance with specified fixed charge coverage and debt to EBITDA ratios. In addition, we are prohibited, without consent from our lenders, from: - incurring or suffering to exist additional indebtedness or liens on our assets, - engaging in any merger, consolidation, acquisition or disposition of assets or other fundamental corporate change, - permitting a change of control of our company, - paying any dividends or making any other distribution on capital stock or other payments in connection with the purchase, redemption, retirement or acquisition of capital stock, - changing our fiscal year or methods of accounting, and - making capital expenditures in excess of $7.15 million during fiscal year 2005 and $3.4 million during fiscal year 2006 and each subsequent fiscal year. Amounts owed related to the magazine export agreement consist of 9 quarterly payments of approximately $.4 million beginning in January 2004. The balance outstanding under this agreement at October 31, 2004 was $2.16 million In connection with the acquisition of the assets of Empire, the Company issued notes payable totaling $1.2 million to Empire and one of the former owners of Empire. The notes payable bear interest at the lowest rate per annum allowable under the Internal Revenue Service Code Section 1274, which was 2.35% as of October 31, 2004. A note payable, due in fiscal 2003, in the principal amount of $1.6 million to the previous owner of an acquired company was being disputed by the Company under the conditions of the acquisition agreement. The Company received a favorable arbitration ruling during the fourth quarter of fiscal 2004, and in March 2004, we settled the remaining note payable, interest accrued thereon and the indemnification claim by the Company for $1.6 million. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management's Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Senior Management has discussed the development, selection and disclosure of these estimates with the Audit Committee of the Board of Directors. Actual results may differ from these estimates under different assumptions and conditions. Management believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements. Revenue Recognition 27 We record a reduction in revenue for estimated magazine sales returns and a reduction in cost of sales for estimated magazine purchase returns. Estimated sales returns are based on historical sales returns and daily point-of-sale data from significant customers. The purchase return estimate is calculated from the sales return reserve based on historical gross profit. If the historical data we use to calculate these estimates does not properly reflect future results, revenue and/or cost of sales may be misstated. Allowance for Doubtful Accounts We provide for potential uncollectible accounts receivable based on customer-specific information and historical collection experience. If market conditions decline, actual collection experience may not meet expectations and may result in increased bad debt expenses. Taxes on Earnings The carrying value of our net deferred tax assets assumes that we will be able to generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions. If these estimates and assumptions change in the future, we may be required to increase or decrease valuation allowances against its deferred tax assets resulting in additional income tax expenses or benefits. Valuation of Long-Lived Assets Including Goodwill and Purchased Intangible Assets We review property, plant and equipment, goodwill and purchased intangible assets for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. Our asset impairment review assesses the fair value of the assets based on the future cash flows the assets are expected to generate. An impairment loss is recognized when estimated discounted future cash flows expected to result from the use of the asset plus net proceeds expected from the disposition of the asset (if any) are less than the carrying value of the asset. This approach uses our estimates of future market growth, forecasted revenue and costs, expected periods the asset will be utilized and appropriate discount rates. Such evaluations of impairment of long-lived assets including goodwill and purchased intangible assets are an integral part of, but not limited to, our strategic reviews of our business and operations. Deterioration of our business overall or within a business segment in the future could also lead to impairment adjustments as such issues are identified. INTERNAL CONTROLS OVER FINANCIAL REPORTING The Company is currently undergoing the rigorous process to ensure compliance with the new regulations under Section 404 of the Sarbanes-Oxley Act that take effect for the Company's fiscal year ending January 31, 2005. In the course of documenting and testing, certain aspects of our internal controls over financial reporting have been identified that we believe require remediation. In these instances, the company has implemented such remediation. While we continue to dedicate substantial resources to this effort we can not be certain that all remediation efforts will be timely completed and tested by us and our independent auditor so that management and our independent auditor will be able to express an unqualified opinion on the effectiveness of internal control for our fiscal year ending January 31, 2005. 28 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our primary market risks include fluctuations in interest rates and exchange rate variability. Our debt relates to credit facilities with Wells Fargo Foothill and a note payable to Hilco Capital. See "--- Liquidity and Capital Resources - --- Debt" The revolving credit facility with Wells Fargo Foothill has an outstanding principal balance of approximately $20.70 million at October 31, 2004. Interest on the outstanding balance is charged based on a variable interest rate related to the prime rate (4.75% at October 31, 2004) plus a margin specified in the credit agreement (0.00% at October 31, 2004). The amended credit facility provides for a $10 million term note payable that bears interest at the prime rate plus 2.0% (6.75% at October 31, 2004). The term note is payable over five years in installments of $0.25 million over four quarters beginning October 31, 2004. The quarterly installments increase to $0.35, $0.50, $0.65 and $0.75 million, respectively, over the subsequent four years. The original term note payable with Wells Fargo Foothill was paid in full in March 2004. The note payable with Hilco Capital was repaid in full during the quarter ended October 31, 2004. Interest expense from these credit facilities is subject to market risk in the form of fluctuations in interest rates. In March 2004, we utilized the proceeds from a sale of our common stock to pay-down all but a nominal amount of the Hilco Capital Note Payable, repay the term note portion of the Wells Fargo Foothill credit facility, and repaid all outstanding balances owed under the revolving credit partition of the Wells Fargo Foothill credit facility. We do not perform any interest rate hedging activities related to these two facilities. We have exposure to foreign currency fluctuations through our operations in Canada. These operations accounted for approximately $2.0 million, which represented 2.1% of our revenues for the quarter ended October 31, 2004. We generally pay the operating expenses related to these revenues in the corresponding local currency. We will be subject to any risk for exchange rate fluctuations between such local currency and the dollar. Additionally, we have exposure to foreign currency fluctuation through our exporting of foreign magazines and the purchased of foreign magazine for domestic distribution. Revenues derived from the export of foreign titles (or sale to domestic brokers who facilitate the export) totaled $28.7 million for the period ended October 31, 2004 or 13.4% of total revenues. For the most part, our export revenues are denominated in dollars and the foreign wholesaler is subject to foreign currency risks. We have the availability to control foreign currency risk via increasing or decreasing the local cover price paid in the foreign markets. There is a risk that a substantial increase in local cover price due to a decline in the local currency relative to the dollar could decrease demand for these magazines at retail and negatively impact our results of operations. Domestic distribution (gross) of imported titles totaled approximately $68.4 million (of a total $381.1 million or 17.9%). Foreign publications are purchased in both dollars and the local currency of the foreign publisher, primarily Euros and pound sterling. In the instances where we buy in the foreign currency, we generally have the ability to set the domestic cover price, which allows us to control the foreign currency risk. Foreign titles generally have significantly higher cover prices then comparable domestic titles, are considered somewhat of a luxury item, are sold only at select retail locations, and sales do not appear to be highly impacted by cover price increases. However, a significant negative change in the relative strength of the dollar to these foreign currencies could result in higher domestic cover prices and result in lower sales of these titles at retail, which would negatively impact our results of operations. We do not conduct any significant hedging activities related to foreign currency. 29 ITEM 4. CONTROLS AND PROCEDURES QUARTERLY CONTROLS EVALUATION AND RELATED CEO AND CFO CERTIFICATIONS Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report (the "Evaluation Date"). Attached as exhibits to this Quarterly Report are certifications of our chief executive officer and chief financial officer, which are required in accordance with Rule 13a-14 of the Securities Exchange Act of 1934, as amended (Exchange Act). The information appearing below should be read in conjunction with the certifications for a more complete understanding of the topics presented. ABOUT DISCLOSURE CONTROLS Disclosure controls and procedures (as defined in Rule 13a-15(e) or Rule 15d-15(e) of the Securities Exchange Act of 1934) are designed to provide assurance that the information concerning us and our consolidated subsidiaries, which is required to be included in our reports and statements filed or submitted under the Securities Exchange Act of 1934, as amended, (i) is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions required disclosure and (ii) is recorded, processed, summarized and reported within the time periods specified in rules and forms of the Securities and Exchange Commission. LIMITATIONS ON THE EFFECTIVENESS OF CONTROLS Our management, including our chief executive officer and chief financial officer, do not expect that our disclosure controls and procedures will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system's objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. SCOPE OF THE CONTROLS EVALUATION The evaluation of our disclosure controls and procedures included a review of the controls' objectives and design, the company's implementation of the controls and the effect of the controls on the information generated for use in this Quarterly Report. In the course of the controls evaluation, we sought to identify data errors, control problems or acts of fraud and confirm that appropriate corrective action, including process improvements, were being undertaken. This type of evaluation is performed on a quarterly basis so that the conclusions of management, including the chief executive officer and the chief financial officer, concerning the effectiveness of the controls can be reported in our Quarterly Reports on Form 10-Q and to supplement our disclosures made in our Annual Report on Form 10-K. Many of the components of our disclosure controls and procedures are also evaluated on an ongoing basis by our Internal Audit Department and by other personnel in our finance organization. The overall goals of these various evaluation activities are to monitor our disclosure controls and procedures, and to modify them as necessary. Our intent is to maintain the disclosure controls and procedures as dynamic systems that change as conditions warrant. 30 CONCLUSIONS Based on this evaluation, our management, including our principal executive officer and principal financial officer, concluded that, as of the Evaluation Date and subject to the limitations noted above, our disclosure controls and procedures were effective to provide reasonable assurance that material information relating to the company is made known to management, including the principal executive officer and principal financial officer, particularly during the period when our periodic reports are being prepared. In addition, there were no changes in our internal controls over financial reporting identified in connection with the above-mentioned evaluation that occurred during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. In addition, we have not identified any significant deficiencies or material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect our ability to record, process, summarize and report financial information. 31 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS We are party to routine legal proceedings arising out of the normal course of business. Although it is not possible to predict with certainty the outcome of these unresolved legal actions or the range of possible loss, we believe that none of these actions, individually or in the aggregate, will have a material adverse effect on our financial condition or results of operations. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Not Applicable ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not Applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. ITEM 5. OTHER INFORMATION Not Applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits. See Exhibit Index (b) Reports on Form 8-K. During the quarter ended October 31, 2004, the Company filed three Reports on Form 8-K as described below: DATE FILED ITEM REPORTED FINANCIAL STATEMENTS FILED ---------- ------------- -------------------------- 1.01, 2.03 September 9, 2004 and 9.01 none Condensed Consolidated Balance Sheets and Statements of Operations at July 31, 2004 and January 31, 2004 and for the fiscal quarter ended September 13, 2004 2.02 July 31, 2004 and 2003 1.02, 2.03 September 16, 2004 and 9.01 none 32 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: December 10, 2004 SOURCE INTERLINK COMPANIES, INC. /s/ Marc Fierman ---------------------------- Marc Fierman Chief Financial Officer 33 EXHIBIT INDEX Exhibit Number Description - ------ ----------- 10.33.2 Second Amendment to Net Lease between Conewago Contractors, Inc. and Pennsylvania International Distribution Services, Inc. effective December 1, 2004 10.48* Retail Magazine Supply Agreement between Barnes & Noble, Inc. and International Periodical Distributors, Inc. dated as of August 6, 2004 31.1 Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer 31.2 Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer 32.1 Section 1350 Certification of Principal Executive Officer and Principal Financial Officer * Certain material has been omitted pursuant to a request for confidential treatment and such material has been filed separately with the Commission.