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 July 31, 2005
[ ] 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)
DELAWARE 20-2428299
- --------------------------------------------------------------------------------
(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 a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
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 September 6, 2005
- --------------------------- --------------------------------
Common Stock, $.01 Par Value 51,298,539
SOURCE INTERLINK COMPANIES, INC.
INDEX
PART I - FINANCIAL INFORMATION
Page
ITEM 1. FINANCIAL STATEMENTS
Consolidated Balance Sheets as of
July 31, 2005 and January 31, 2005 1
Consolidated Statements of Income for the three
and six months ended July 31, 2005 and 2004 3
Consolidated Statement of Stockholders'
Equity for the six months ended July 31, 2005 4
Consolidated Statements of Cash Flows for the
six months ended July 31, 2005 and 2004 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 36
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 36
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 36
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 36
ITEM 5. OTHER INFORMATION 36
ITEM 6. EXHIBITS 36
312-681-6200
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)
July 31, 2005 January 31, 2005
------------- ----------------
ASSETS
CURRENT ASSETS
Cash $ 4,108 $ 1,387
Trade receivables, net 97,913 48,078
Purchased claims receivable 9,996 2,006
Inventories 172,038 16,868
Income tax receivable 1,577 2,275
Deferred tax asset 11,202 2,302
Prepaid expenses and other 7,417 3,349
--------- ---------
TOTAL CURRENT ASSETS 304,251 76,265
--------- ---------
Property and equipment 86,461 36,706
Less accumulated depreciation and amortization (18,553) (14,375)
--------- ---------
Net property and equipment 67,908 22,331
--------- ---------
OTHER ASSETS
Goodwill, net 206,123 71,600
Intangibles, net 226,748 16,126
Deferred tax asset 5,204 2,903
Other 8,186 8,528
--------- ---------
TOTAL OTHER ASSETS 446,261 99,157
--------- ---------
$ 818,420 $ 197,753
========= =========
1 See accompanying notes to
Consolidated Financial Statements
CONSOLIDATED BALANCE SHEETS
(in thousands, except par value)
(unaudited)
July 31, 2005 January 31, 2005
------------- ----------------
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Checks issued against future advances on revolving credit facility $ 6,010 $ 1,951
Accounts payable and accrued expenses, net of allowances for returns of
$140,201 and $70,292, respectively 252,024 25,274
Deferred revenue 2,254 2,205
Other 1,758 19
Current maturities of long-term debt 4,601 5,630
Current portion of obligations under capital leases 196 -
--------- ---------
TOTAL CURRENT LIABILITIES 266,843 35,079
Long-term debt, less current maturities 96,889 34,139
Obligations under capital leases 345 -
Other 6,879 852
--------- ---------
TOTAL LIABILITIES 370,956 70,070
--------- ---------
COMMITMENTS AND CONTINGENCIES (NOTE 7)
STOCKHOLDERS' EQUITY
Contributed Capital:
Common Stock, $.01 par; 100,000 and 40,000 shares authorized, respectively;
51,296 and 23,849 shares issued, respectively 512 238
Additional paid-in-capital 464,794 150,269
--------- ---------
Total contributed capital 465,306 150,507
Accumulated deficit (19,395) (23,696)
Accumulated other comprehensive income:
Foreign currency translation 1,553 1,439
--------- ---------
447,464 128,250
Less: Treasury Stock (100 shares at cost) - (567)
--------- ---------
TOTAL STOCKHOLDERS' EQUITY 447,464 127,683
--------- ---------
$ 818,420 $ 197,753
========= =========
2 See accompanying notes to
Consolidated Financial Statements
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
(in thousands, except per share data)
Three months ended July 31, Six months ended July 31,
2005 2004 2005 2004
--------- --------- --------- ---------
Revenues $ 393,790 $ 86,858 $ 628,211 $ 169,039
Cost of revenues 314,801 63,182 498,677 123,284
--------- --------- --------- ---------
Gross profit 78,989 23,676 129,534 45,755
Selling, general and administrative expenses 46,958 12,079 76,633 24,028
Fulfillment freight 18,354 4,759 28,690 9,632
Depreciation and amortization 4,241 949 7,344 1,626
Relocation charges - - 1,552
Merger and acquisition charges - - 3,094 -
--------- --------- --------- ---------
Operating income 9,436 5,889 13,773 8,917
--------- --------- --------- ---------
Other income (expense)
Interest expense (1,744) (124) (2,678) (660)
Interest income 44 39 90 106
Write off of deferred financing costs and original issue
discount - - - (1,494)
Other income 61 149 135 40
--------- --------- --------- ---------
Total other income (expense) (1,639) 64 (2,453) (2,008)
--------- --------- --------- ---------
Income from continuing operations before income taxes and 7,797 5,953 11,320 6,909
discontinued operation
Income tax expense 3,721 1,889 5,573 2,213
Income from continuing operations before discontinued operation 4,076 4,064 5,747 4,696
Income (loss) from discontinued operation, net of tax (1,446) 74 (1,446) (61)
--------- --------- --------- ---------
Net income $ 2,630 $ 4,138 $ 4,301 $ 4,635
========= ========= ========= =========
Earnings (loss) per share - basic
Continuing operations $ 0.08 $ 0.18 $ 0.12 $ 0.21
Discontinued operation (0.03) 0.00 (0.03) 0.00
--------- --------- --------- ---------
Total $ 0.05 $ 0.18 $ 0.09 $ 0.21
--------- --------- --------- ---------
Earnings (loss) per share - diluted
Continuing operations $ 0.08 $ 0.16 $ 0.12 $ 0.19
Discontinued operation (0.03) 0.00 (0.03) 0.00
--------- --------- --------- ---------
Total $ 0.05 $ 0.16 $ 0.09 $ 0.19
--------- --------- --------- ---------
Weighted average of shares outstanding - basic 51,140 23,241 46,800 22,398
Weighted average of shares outstanding - diluted 52,960 25,026 48,751 24,466
========= ========= ========= =========
3 See accompanying notes to
Consolidated Financial Statements
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(unaudited)
(in thousands)
Accumulated
Additional Other Total
Common Stock Paid - in Accumulated Comprehensive Treasury Stock Stockholders'
--------------- ----------------
Shares Amount Capital Deficit Income Shares Amount Equity
------ ------ ---------- ----------- ------------- ------ -------- -------------
Balance January 31, 2005 23,849 $ 238 $ 150,269 $ (23,696) $ 1,439 100 $ (567) $ 127,683
Net income - - - 4,301 - - - 4,301
Foreign currency translation - - - - 114 - - 114
---------
Comprehensive income - 4,415
---------
Exercise of stock options 605 6 3,050 - - - - 3,056
Tax benefit from stock options exercised - - 1,096 - - - - 1,096
Stock issued in Alliance acquisition 26,942 269 304,445 - - - - 304,714
Exchange of stock options and warrants
to acquire Alliance common stock - - 6,500 - - - - 6,500
Retirement of treasury stock (100) (1) (566) - - (100) 567 -
------ ------ - -------- --------- -------- ------ -------- ---------
Balance July 31, 2005 51,296 $ 512 $ 464,794 $ (19,395) $ 1,553 - $ - $ 447,464
====== ====== ========== ========= ======== ====== ======== =========
4 See accompanying notes to
Consolidated Financial Statements
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)
Six months ended July 31, 2005 2004
- --------------------------------------------------------------------------- -------- --------
OPERATING ACTIVITIES
Net income $ 4,301 $ 4,635
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Depreciation and amortization 8,242 2,560
Provision for losses on accounts receivable 1,725 404
Deferred income taxes - (240)
Tax benefit from stock options exercised 1,096 -
Deferred revenue 139 -
Write off of deferred financing costs and original issue discount - 1,494
Other (74) (303)
Changes in assets and liabilities (excluding business acquisitions):
Increase in accounts receivable (981) (15,228)
(Increase) decrease in inventories (15,179) 1,494
Decrease in other assets 4,665 285
Increase in accounts payable and other liabilities 11,445 3,028
-------- --------
CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES 15,379 (1,871)
-------- --------
INVESTING ACTIVITIES
Capital expenditures (6,120) (3,156)
Purchase of claims (54,280) (43,599)
Payments received on purchased claims 46,290 46,915
Collections under magazine export agreement - 3,061
Payments under magazine import agreement - (1,500)
Net cash from Alliance Entertainment Corp. acquisition 16,878 -
Acquisition of distribution rights (2,300) -
Proceeds from sale of fixed assets 1,480 -
Acquisition of Chas. Levy Circulating Company LLC, net of cash acquired (44,991) -
-------- --------
CASH (USED IN) PROVIDED BY INVESTING ACTIVITIES (43,043) 1,721
-------- --------
FINANCING ACTIVITIES
Decrease in checks issued against revolving credit facilities (7,517) (8,801)
Net borrowings (repayments) under credit facilities 55,210 (9,757)
Payments on debt and capital leases (19,316) (21,510)
Net proceeds from the issuance of common stock 3,056 43,802
Deferred financing costs (1,048) -
-------- --------
CASH PROVIDED BY FINANCING ACTIVITIES 30,385 3,734
-------- --------
INCREASE IN CASH 2,721 3,584
CASH, beginning of period 1,387 4,963
-------- --------
CASH, end of period $ 4,108 $ 8,547
======== ========
5 See accompanying notes to
Consolidated Financial Statements
BASIS OF PRESENTATION
The consolidated financial statements included herein have been prepared by
Source Interlink Companies, Inc. (the Company), without audit, pursuant to the
rules and regulations of the Securities and Exchange Commission. In the opinion
of the Company's management, all adjustments (consisting only of normal
recurring adjustments and reclassifications) necessary to present fairly our
results of operations for the three and six months ended July 31, 2005 and July
31, 2004, our financial position as of July 31, 2005, and cash flows for the six
months ended July 31, 2005 and 2004, respectively. The results of operations for
such interim periods are not necessarily indicative of the operating results to
be expected for the full year.
Certain information and disclosures normally included in the notes to the annual
consolidated financial statements have been condensed or omitted from these
interim consolidated financial statements. Accordingly, these interim
consolidated financial statements should be read in conjunction with the
consolidated financial statements and notes thereto included in our Annual
Report on Form 10-K (the "Annual Report") for the fiscal year ended January 31,
2005, as filed with the Securities and Exchange Commission ("SEC") on April 18,
2005.
Certain reclassifications have been made to conform to the current period
presentation. These reclassifications had no effect on the results of operations
or stockholders' equity.
1. BUSINESS COMBINATIONS
CHAS. LEVY CIRCULATING CO. LLC ACQUISITION
On May 10, 2005, the Company and Chas. Levy Company LLC ("Seller") entered into
a Unit Purchase Agreement (the "Purchase Agreement"). Under the terms of the
Purchase Agreement, the Company purchased all of the issued and outstanding
membership interests in Chas. Levy Circulating Co. LLC ("Levy") from Chas. Levy
Company LLC for a purchase price of approximately $30 million, subject to
adjustment based on Levy's net worth as of the closing date of the transaction.
Seller was the sole member of Levy. In addition, approximately $19.3 million was
also provided on the date of acquisition to Seller to repay all outstanding
intercompany debt of Levy. The purchase price and the intercompany debt
repayment were funded from the revolving line of credit.
On May 10, 2005, as contemplated by the terms of the Purchase Agreement, the
Company and Levy Home Entertainment LLC ("LHE") entered into a Distribution and
Supply Agreement (the "Distribution Agreement"). Under the terms of the
Distribution Agreement, LHE appointed the Company as its sole and exclusive
subdistributor of book products to all supermarkets (excluding supermarkets
combined with general merchandise stores), drug stores, convenience stores,
newsstands and terminals within the geographic territory in which the Registrant
currently distributes DVDs, CDs and/or magazines. The initial term of the
Distribution Agreement begins on May 10, 2005 and expires on June 30, 2015. The
parties may renew the agreement thereafter for successive one year periods.
The total cost of the acquisition was allocated to the assets acquired and
liabilities assumed based on their respective fair values in accordance with FAS
141, Business Combinations. Goodwill, which is deductible for tax purposes,
recorded in connection with the transaction totaled $84.1 million. These amounts
will be tested at least annually for impairment in accordance with FAS No. 142,
Goodwill and Other Intangible Assets.
The assets acquired and liabilities assumed in the acquisition were recorded in
the quarter ended July 31, 2005. The acquisition was accounted for by the
purchase method and, accordingly, the results of Levy's operations have been
included in our consolidated statements of income since May 10, 2005. The pro
forma operating results as if the Company had completed the acquisition at the
beginning of the periods presented are not significant to the Company's
consolidated financial statements and are not presented.
Goodwill at the date of acquisition of Levy is based on a preliminary
independent valuation study, therefore reported amounts may change based on
finalization which is expected to occur during the third quarter of fiscal 2006.
6
The assets acquired and liabilities assumed in the acquisition are summarized
below (in thousands):
Cash $ 4,276
Trade receivables, net 2,874
Inventories 37,557
Property and equipment 1,524
Goodwill and other intangible assets 84,085
Other assets 2,962
Accounts payable and accrued liabilities (68,580)
Long-term debt (13,995)
Other long-term liabilities (1,436)
---------
Total consideration $ 49,267
---------
ALLIANCE ENTERTAINMENT CORP. ACQUISITION
On February 28, 2005, the Company completed its acquisition with Alliance
Entertainment Corp. ("Alliance") pursuant to the terms and conditions of the
Agreement and Plan of Merger Agreement dated November 18, 2004 (the
"Agreement"). Alliance provides full-service distribution of home entertainment
products. They provide product and commerce solutions to "brick-and-mortar" and
e-commerce retailers, while maintaining trading relationships with major
manufacturers in the home entertainment industry.
The purchase price of approximately $315.5 million consisted of $304.7 million
in the Company's common stock, representing approximately 26.9 million shares,
$6.5 million related to the exchange of approximately 0.9 million options to
acquire shares of common stock on exercise of outstanding stock options,
warrants and other rights to acquire Alliance common stock and direct
transaction costs of approximately $4.3 million. The value of the common stock
was determined based on the average market price of Source Interlink common
stock over the 5-day period prior to and after the announcement of the
acquisition in November 2004. The value of the stock options was determined
using the Black-Scholes option valuation model.
The total cost of the acquisition was allocated to the assets acquired and
liabilities assumed based on their respective fair values in accordance with FAS
141, Business Combinations. Goodwill and other intangible assets, none of which
is deductible for tax purposes, recorded in connection with the transaction
totaled $50.5 million and $211.5 million, respectively. These amounts will be
tested at least annually for impairment in accordance with FAS No. 142, Goodwill
and Other Intangible Assets.
The assets acquired and liabilities assumed in the acquisition were recorded in
the quarter ended April 30, 2005. The acquisition was accounted for by the
purchase method and, accordingly, the results of Alliance's operations have been
included in our consolidated statements of income since March 1, 2005.
7
The assets acquired and liabilities assumed in the acquisition are summarized
below (in thousands):
Cash $ 18,567
Trade receivables, net 47,806
Inventories 102,434
Property and equipment 43,696
Goodwill 50,520
Intangible assets 211,525
Other assets 17,465
Accounts payable and accrued liabilities (160,156)
Obligations under capital leases (563)
Long-term debt (11,811)
Other long-term liabilities (4,000)
----------
Total consideration $ 315,483
----------
The acquisition was accounted for by the purchase method and, accordingly, the
results of Alliance's operations have been included in our consolidated
statements of income since March 1, 2005. The following table summarizes pro
forma operating results as if the Company had completed the acquisition on
February 1, 2004 (in thousands, except per share data):
Three months ended July 31, Six months ended July 31,
--------------------------- -------------------------
2005 2004 2005 2004
---------- ----------- ---------- -----------
Revenues $ 393,790 $ 294,555 $ 701,405 $ 602,728
Net income 2,630 6,577 5,957 10,532
Earnings per share - basic
Continuing operations 0.08 0.13 0.14 0.21
Discontinued operation (0.03) - (0.03) -
---------- ----------- ---------- -----------
Total 0.05 0.13 0.11 0.21
========== =========== ========== ===========
Earnings per share -- diluted
Continuing operations 0.08 0.12 0.14 0.20
Discontinued operation (0.03) - (0.03) -
---------- ----------- ---------- -----------
Total 0.05 0.12 0.11 0.20
========== =========== ========== ===========
This information has been prepared for comparative purposes only and does not
purport to be indicative of the results of operations which actually would have
resulted had the acquisition occurred on February 1, 2004, nor is it indicative
of future results.
Merger charges related to the acquisition recorded as expenses by the Company
through July 31, 2005 totaled $3.1 million. These expenses represented severance
and personnel-related charges, charges to exit certain merchandiser contracts
and a success fee paid to certain Company executives. These expenses were not
capitalized as they did not represent costs that provide future economic
benefits to the Company.
8
2. TRADE RECEIVABLES
Trade receivables consist of the following (in thousands):
July 31, 2005 January 31, 2005
------------- ----------------
Trade receivables $ 285,949 $ 129,031
Allowances:
Sales returns and other (168,190) (78,404)
Doubtful accounts (19,846) (2,549)
--------- -----------
(188,036) (80,953)
--------- -----------
Net trade receivables $ 97,913 $ 48,078
========= ===========
3. INVENTORIES
Inventories consist of the following (in thousands):
July 31, 2005 January 31, 2005
------------- ----------------
Raw materials $ 2,466 $ 2,657
Work-in-process 2,669 1,459
Finished goods:
Pre-recorded music and video 113,751 -
Magazine and book 50,014 11,345
Fixtures 3,138 1,407
---------- ----------
Inventories $ 172,038 $ 16,868
========== ==========
In the event of non-sale, pre-recorded music and video, magazine and book
inventories are generally returnable to the suppliers thereof for full credit.
4. PROPERTY AND EQUIPMENT
Property and equipment consists of the following (in thousands):
JULY 31, JANUARY 31,
2005 2005
-------- -----------
Land $ 8,218 $ 870
Buildings 17,406 8,809
Leasehold improvements 4,837 2,566
Machinery and equipment 30,789 10,806
Vehicles 483 354
Furniture and fixtures 8,673 3,855
Computers 13,161 9,446
Construction in progress 2,894 -
-------- --------
Property and equipment $ 86,461 $ 36,706
======== ========
Depreciation expense from property and equipment was $2.4 million and $4.2
million for the three and six months ended July 31, 2005 and $1.0 million and
$1.9 million for the three and six months ended July 31, 2004, respectively.
9
5. GOODWILL AND INTANGIBLE ASSETS
A summary of the Company's intangible assets is as follows (in thousands):
July 31, January 31,
2005 2005
--------- -----------
Amortized intangible assets:
Customer lists $ 97,630 $ 16,025
Non-compete agreements 1,775 1,000
Software 12,948 -
Unamortized intangible assets including vendor lists 119,000 -
--------- ---------
231,353 17,025
Accumulated amortization (4,605) (899)
--------- ---------
Intangibles, net $ 226,748 $ 16,126
--------- ---------
Amortization expense from intangible assets was $1.9 million and $3.5 million
for the three and six months ended July 31, 2005, respectively and $0.2 million
and $0.4 million for the three and six months ended July 31, 2004, respectively.
Amortization expense will approximate $8.0 million for each of the next five
fiscal years.
The changes in the carrying amount of goodwill for the six months ended July 31,
2005, are as follows:
Foreign currency
January 31, translation Working capital July 31,
2005 Additions adjustments adjustments 2005
----------- --------- ---------------- --------------- ----------
Goodwill $ 71,600 135,049 80 (606) $ 206,123
---------- ------- -- ---- ----------
6. DEBT AND REVOLVING CREDIT FACILITY
Debt consists of (in thousands):
July 31, January 31,
2005 2005
-------- ----------
Revolving Credit facility - Wells Fargo Foothill $ 74,499 $ 19,289
Note payable - Wells Fargo Foothill - 8,766
Note payable - magazine import and export 7,566 9,879
Notes payable -- former owner of Empire 1,200 1,200
Notes payable - arrangements with suppliers 13,995 -
Mortgage loan - SunTrust Bank - -
Equipment loans - SunTrust Leasing 3,817 -
Other 413 635
-------- ---------
Debt 101,490 39,769
Less current maturities 4,601 5,630
-------- ---------
Debt, less current maturities $ 96,889 $ 34,139
======== =========
WELLS FARGO FOOTHILL CREDIT FACILITY
On February 28th 2005, the Company modified its existing credit facility with
Wells Fargo Foothill ("WFF") as a result of its acquisition of Alliance
Entertainment Corp. The primary changes from the original line of credit were to
(1) increase the maximum allowed advances under the line of credit from $45
million to $250 million and (2) extend the maturity date from October 2009 to
October 2010. In addition, in conjunction with the modification of the existing
credit facility, the Company repaid the balance of its $10 million WFF term
loan. WFF, as arranger and administrative agent for each of the parties that may
become a participant in such arrangement and their successors ("Lenders") will
make revolving loans to us and our subsidiaries of up to $250 million including
the issuance of letters of credit. The terms and conditions of the arrangement
are governed primarily by the Amended and Restated Loan Agreement dated February
28, 2005 by and among us, our subsidiaries, and WFF.
10
Outstanding borrowings bear interest at a variable annual rate equal to the
prime rate announced by Wells Fargo Bank, National Association's San Francisco
office, plus a margin of between 0.0% and 1.00% (applicable margin was 0.0% at
July 31, 2005) based upon a ratio of the Company's EBITDA to interest expense
("Interest Coverage Ratio"). At July 31, 2005 the prime rate was 6.25%. We also
have the option of selecting up to five traunches of at least $1 million each to
bear interest at LIBOR plus a margin of between 2.00% and 3.00% based upon our
Interest Coverage Ratio. The Company has three LIBOR contracts outstanding at
July 31, 2005 (expiring September 2005) and bears interest at a weighted average
rate of approximately 5.55%. To secure repayment of the borrowings and other
obligations of ours to the Lenders, we and our subsidiaries granted a security
interest in all of the personal property assets to WFF, for the benefit of the
Lenders. These loans mature on October 31, 2010.
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. The Company was in compliance with these
ratios at July 31, 2005.
Availability under the facility is limited by the Company's borrowing base
calculation, as defined in the agreement. The calculation resulted in excess
availability, after consideration of outstanding letters of credit, of $75.0
million at July 31, 2005.
MORTGAGE LOAN
Through the acquisition of Alliance, the Company obtained an $8.5 million
conventional mortgage loan through SunTrust Bank (the "SunTrust Mortgage"). The
SunTrust Mortgage was collateralized by land and building. The SunTrust Mortgage
monthly principal payments were approximately $31,000 plus interest at a rate of
LIBOR plus 2 1/2 percent. During July 2005, the aggregate unpaid principal
balance of the mortgage, accrued and unpaid interest and all costs and expenses
due under the SunTrust Mortgage terms were paid in full.
EQUIPMENT LOANS
Through the acquisition of Alliance, the Company entered into a loan agreement
with SunTrust Leasing Corporation (the "SunTrust Loan") for the purchase of
equipment to be used at various locations. A credit line of $6.8 million was
approved under the SunTrust Loan, with repayment terms for five promissory notes
ranging from three to five years. The total principal balance of the SunTrust
Loan outstanding as of July 31, 2005 was $3.8 million.
SUPPLIER LOANS
Through the acquisition of Levy, the Company assumed four notes payable with
suppliers (the "Supplier Notes") totaling $14.0 million. The maturity dates of
the supplier notes range between March 2007 and August 2014 and bear interest at
5%. Principal repayments range from $1.0 to $2.0 million per fiscal year with
$2.1 million and $1.9 million due to be repaid in fiscal year 2006 and 2007,
respectively. The total principal balance of the supplier notes as of July 31,
2005 is approximately $14.0 million.
11
The maturity schedule of the Company's long-term debt is as follows (in
thousands):
Fiscal year Amount
- ----------------------------- ---------
2006 $ 4,601
2007 6,623
2008 6,134
2009 3,370
2010 1,213
Thereafter 79,549
---------
101,490
Less current maturities 4,601
---------
Debt, less current maturities $ 96,889
=========
7. COMMITMENTS AND CONTINGENCIES
The Company leases facilities, vehicles, an aircraft, computer and other
equipment under various capital and operating leases. Future minimum payments
under capital and noncancelable operating leases with terms of one year or more
at July 31, 2005 consist of the following (dollars in thousands):
OPERATING
LEASES
---------
2006 $ 6,556
2007 10,409
2008 8,776
2009 7,831
2010 6,829
Thereafter 20,800
--------
$ 61,201
========
8. DISCONTINUED OPERATION
In November 2004, the Company sold and disposed of its secondary wholesale
distribution operation for $1.4 million, in order to focus more fully on its
domestic and export distribution. All rights owned under the secondary wholesale
distribution contracts were assigned, delivered, conveyed and transferred to the
buyer, an unrelated third party. All assets and liabilities of the secondary
wholesale distribution operation were not assumed by the buyer. The Company
recognized a gain on sale of this business of $1.4 million ($0.8 net of tax) in
the fourth quarter of fiscal year 2005. In the second quarter of fiscal 2006,
the Company wrote off certain accounts receivable totaling $1.4 million, net of
tax.
The following amounts related to the Company's discontinued operation have been
segregated from continuing operations and reflected as discontinued operations
(in thousands):
Three months ended July 31, Six months ended July 31,
--------------------------- -------------------------
2005 2004 2005 2004
------- -------- -------- -------
Revenues $ - $ 4,583 $ - $ 8,089
------- -------- -------- -------
(Loss) income before taxes (2,410) 123 (2,410) (102)
Income tax benefit (expense) 964 (49) 964 41
------- -------- -------- -------
(Loss) income from discontinued operation, net of tax $(1,446) $ 74 $ (1,446) $ (61)
======= ======== ======== =======
12
9. 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 Six Months Ended
July 31, July 31,
2005 2004 2005 2004
------- ------ ------ ------
Basic weighted average number of common shares outstanding 51,140 23,241 46,800 22,398
Effect of dilutive securities:
Stock options and warrants 1,820 1,785 1,951 2,068
------ ------ ------ ------
Diluted weighted average number of common shares outstanding 52,960 25,026 48,751 24,466
====== ====== ====== ======
For the quarter ended July 31, 2005, stock options to purchase 0.3 million
shares and warrants convertible into 0.01 million 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.
10. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental information on interest and income taxes paid is as follows (in
thousands):
Six Months Ended July 31, 2005 2004
- ------------------------- ------- -------
Interest $ 2,325 $ 881
Income Taxes $ 2,596 $ 1,109
On February 28, 2005, as discussed in Note 1, the Company acquired Alliance
Entertainment Corp. for the total consideration of $315.5 million as follows (in
thousands):
Fair value of common stock issued to Alliance shareholders $ 304,714
Fair value of options to purchase common stock issued to
Alliance shareholders 6,500
Cash paid for direct acquisition
costs (of which, $1.7 million were paid during the
six months ended July 31, 2005).............................. 4,269
---------
Total purchase price for acquisition of Alliance $ 315,483
=========
The total purchase price was allocated to the assets and liabilities of Alliance
Entertainment Corp as disclosed in Note 1.
13
11. STOCK-BASED COMPENSATION
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. No stock
based compensation was reflected in the period ended July 31, 2005 and 2004 as
all options granted in those years had an exercise price equal to or greater
than the market value of the underlying stock on the date of grant.
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 Six Months Ended
July 31, July 31,
2005 2004 2005 2004
-------- -------- -------- --------
Net income $ 2,530 $ 4,138 $ 4,201 $ 4,635
Stock compensation costs, net of tax (661) (89) (1,331) (178)
-------- -------- -------- --------
Adjusted net income $ 1,869 $ 4,049 $ 2,870 $ 4,457
-------- -------- -------- --------
Weighted average shares, basic 51,140 23,241 46,800 22,398
Weighted average shares, diluted 52,960 25,026 48,751 24,466
Basic earnings per share - as reported $ 0.05 $ 0.18 $ 0.09 $ 0.21
Diluted earnings per share - as reported $ 0.05 $ 0.17 $ 0.09 $ 0.19
Basic earnings per share - pro-forma $ 0.04 $ 0.17 $ 0.06 $ 0.20
Diluted earnings per share - pro-forma $ 0.04 $ 0.16 $ 0.06 $ 0.18
======== ======== ======== ========
The fair value of each option grant is estimated on the grant date using the
Black-Scholes option pricing model with the following assumptions:
July 31, 2005 2004
- ----------------------- --------- ---------
Dividend yield 0% 0%
Expected volatility 0.50 0.50
Risk-free interest rate 3.10-3.75% 2.18-2.25%
======== =========
12. 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 CD and DVD Fulfillment, Magazine
Fulfillment, In-Store Services, and Shared Services. The accounting policies of
the segments are materially the same as those described in the Summary of
Accounting Policies included in our Annual Report on Form 10-K (the "Annual
Report") for the fiscal year ended January 31, 2005, as filed with the
Securities and Exchange Commission ("SEC") on April 18, 2005.
14
Based on the comparability of the operations, Levy's results are included in the
Magazine Fulfillment group. As a result of the acquisition of Alliance on
February 28, 2005, the Company created a CD and DVD Fulfillment reporting
segment. Based on the reporting of the senior management, the previous Wood
Manufacturing group's results are included in the In-Store Services group. The
results of fiscal year 2005 have been restated to conform to this presentation.
The CD and DVD Fulfillment segment derives revenues from (1) selling and
distributing pre-recorded music, videos, video games and related products to
retailers, (2) providing product and commerce solutions to "brick-and-mortar"
and e-commerce retailers, and (3) providing consumer-direct fulfillment and
vendor managed inventory services to its customers.
The Magazine Fulfillment segment derives revenues from (1) selling and
distributing magazines, including domestic and foreign titles, to major
specialty and mainstream retailers and wholesalers throughout the United States
and Canada, (2) exporting domestic titles internationally to foreign wholesalers
or through domestic brokers, (3) providing return processing services for major
specialty retail book chains and (4) 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) designing, manufacturing, shipping,
installation and removal of front-end fixtures, including high end wood and wire
and (4) providing information and management services relating to retail
magazine sales to U.S. and Canadian retailers and magazine publishers.
Shared Services consists of overhead functions not allocated to individual
operating segments.
Segment results from continuing operations follow (in thousands):
CD and DVD Magazine In-Store Other
Three Months Ended July 31, 2005 Fulfillment Fulfillment Services (Shared Services) Consolidated
- --------------------------------- ----------- ----------- ---------- ----------------- ------------
Revenue $ 208,640 $ 166,763 $ 18,387 $ - $ 393,790
Cost of revenue 172,153 130,162 12,486 - 314,801
----------- ----------- ---------- ----------- ----------
Gross profit 36,487 36,601 5,901 - 78,989
Selling, general & administrative 19,873 19,715 2,153 5,217 46,958
Fulfillment freight 6,937 11,417 - - 18,354
Depreciation and amortization 2,836 765 155 485 4,241
----------- ----------- ---------- ----------- ----------
Operating income (loss) $ 6,841 $ 4,704 $ 3,593 $ (5,702) $ 9,436
=========== =========== ========== =========== ==========
Total Assets $ 468,771 $ 207,551 $ 85,173 $ 56,825 $ 818,320
Goodwill, net 50,925 100,737 50,322 4,139 206,123
Intangibles, net 208,687 13,964 4,097 - 226,748
Capital expenditures 2,233 450 79 1,003 3,765
CD and DVD Magazine In-Store Other
Six Months Ended July 31, 2005 Fulfillment Fulfillment Services (Shared Services) Consolidated
- --------------------------------- ----------- ----------- ---------- ----------------- ------------
Revenue $ 357,102 $ 238,416 $ 32,693 $ - $ 628,211
Cost of revenue 293,289 182,902 22,486 - 498,677
----------- ----------- ---------- ---------- -----------
Gross profit 63,813 55,514 10,207 - 129,534
Selling, general & administrative 33,233 28,761 4,309 10,330 76,633
Fulfillment freight 11,604 17,086 - - 28,690
Depreciation and amortization 4,902 1,168 301 973 7,344
Merger and acquisition charges - - 227 2,867 3,094
----------- ----------- ---------- ---------- -----------
Operating income (loss) $ 14,074 $ 8,499 $ 5,370 $ (14,170) $ 13,773
=========== =========== ========== ========== ===========
Capital expenditures $ 3,788 $ 503 $ 237 $ 1,592 $ 6,120
15
CD and DVD Magazine In-Store Other
Three Months Ended July 31, 2004 Fulfillment Fulfillment Services (Shared Services) Consolidated
- --------------------------------- ----------- ----------- ---------- ----------------- ------------
Revenue $ - $ 65,651 $ 21,207 $ - $ 86,858
Cost of revenue - 49,242 13,940 - 63,182
----------- ----------- ---------- ----------- ------------
Gross profit - 16,409 7,267 - 23,676
Selling, general & administrative - 6,682 2,203 3,194 12,079
Fulfillment freight - 4,759 - - 4,759
Depreciation and amortization - 357 36 556 949
----------- ----------- ---------- ----------- ------------
Operating income (loss) $ - $ 4,611 $ 5,028 $ (3,750) $ 5,889
=========== =========== ========== =========== ============
Total Assets $ - $ 61,873 $ 95,285 $ 20,121 $ 177,279
Goodwill, net - - 41,168 4,139 45,307
Intangibles, net - 8,935 89 - 9,024
Capital expenditures - 10 78 1,122 1,210
CD and DVD Magazine In-Store Other
Six Months Ended July 31, 2004 Fulfillment Fulfillment Services (Shared Services) Consolidated
- --------------------------------- ----------- ----------- ---------- ---------------- ------------
Revenue $ - $ 131,406 $ 37,633 $ - $ 169,039
Cost of revenue - 99,604 23,680 - 123,284
----------- ----------- ---------- ----------- ------------
Gross profit - 31,802 13,953 - 45,755
Selling, general & administrative - 13,021 4,446 6,561 24,028
Fulfillment freight - 9,632 - - 9,632
Depreciation and amortization - 653 70 903 1,626
Relocation expense - 1,552 - - 1,552
----------- ----------- ---------- ----------- ------------
Operating income (loss) $ - $ 6,944 $ 9,437 $ (7,464) $ 8,917
=========== =========== ========== =========== ============
Capital expenditures $ - $ 1,010 $ 144 $ 2,002 $ 3,156
13. RELATED PARTY TRANSACTIONS
Pursuant to an agreement through August 2007, the Company conducts significant
business with one customer distributing magazines, music and DVDs. The Chairman
and major stockholder of this customer is a passive minority investor of AEC
Associates, the Company's largest shareholder subsequent to the acquisition of
Alliance Entertainment. Subsequent to the acquisition, the Company had revenues
of $175.4 million to this customer and this customer's subsidiaries.
16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
Some of the information contained in this report, which are not historical
facts, are considered to be "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities and Exchange Act of 1934, as amended. The words "believe," "expect,"
"anticipate,' "estimate," "project," and similar expressions often characterize
forward-looking statements. These statements may include, but are not limited
to, projections of collections, revenues, income or loss, cash flow, estimates
of capital expenditures, plans for future operations, products or services, and
financing needs or plans, as well as assumptions relating to these matters.
These statements are only predictions 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 those set forth
under the heading and those set forth under the heading "Risk Factors that Might
Affect Future Operating Results and Financial Condition" contained in our Annual
Report on Form 10-K for this fiscal year ended January 31, 2005.
- - market acceptance of and continuing demand for magazines, DVDs, CDs and
other home entertainment products;
- - the impact of competitive products and technologies;
- - the pricing and payment policies of magazine publishers, film studios,
record labels and other key vendors;
- - our ability to obtain additional financing to support our operations;
- - changing market conditions and opportunities;
- - our ability to realize operating efficiencies, costs savings and other
benefits from recent and pending acquisitions; and,
- - retention of key management and employees.
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 and those set forth under the heading "Risk Factors that Might Affect
Future Operating Results and Financial Condition" contained in our Annual Report
on Form 10-K for this fiscal year ended January 31, 2005 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.
OVERVIEW
We provide supply chain management and/or related value-added products and
services to most national/regional retailers, magazine publishers and other
providers of home entertainment content. On February 28, 2005 we completed our
merger with Alliance Entertainment Corp., a logistics and supply chain
management services company for the home entertainment product market
principally selling CDs and DVDs. In addition, on May 10, 2005, the Company
acquired Chas. Levy Circulating Co. LLC ("Levy"), a company that primarily
distributes magazines and books to the mainstream market. Following the merger,
we organized the combined company into three main operating business units: CD
and DVD Fulfillment, Magazine Fulfillment and In-Store Services.
ACQUISITION OF ALLIANCE ENTERTAINMENT CORP.
On February 28, 2005, we completed the merger with Alliance Entertainment
Corp, a logistics and supply chain management services company for the home
entertainment product market pursuant to the terms and conditions of the
Agreement and Plan of Merger Agreement dated as of November 18, 2004 (the
"Merger Agreement").
17
Alliance historically operated two business segments: the Distribution and
Fulfillment Services Group ("DFSG") and the Digital Medial Infrastructure
Services Group (the "DMISG"). Prior to the merger, on December 31, 2004,
Alliance disposed of all of the operations conducted by the DMISG business lines
through a spin-off to its existing stockholders. Consequently, in connection
with the merger, we acquired only the DFSG business and not the DMISG business.
The DMISG business represented approximately 1.8% and 1.4% of Alliance's
consolidated sales for the years ended December 31, 2004 and 2003, respectively.
We consummated the merger with Alliance to further our objective of creating the
premier provider of information, supply chain management and logistics services
to retailers and producers of home entertainment content products. We believe
that the merger provides significant market opportunities to take advantage of
our strong retailer relationships and experience in marketing our products by
expanding product offerings beyond our existing magazine fulfillment business to
DVDs, CDs, video games and related home entertainment products and accessories.
In addition, we believe that our in-store merchandising capabilities will be
strengthened. We also believe this transaction will position us as the
distribution channel of choice for film studios, record labels, publishers and
other producers of home entertainment content products. We expect to benefit
from substantial cost savings in the areas of procurement, marketing,
information technology and administration and from other operational
efficiencies, particularly in the distribution and fulfillment functions, where
we plan to consolidate some distribution operations, reorganize others and
leverage our best practices across all of our distribution operations. As a
result, we believe the merger will enhance our financial strength, increase our
visibility in the investor community and strengthen our ability to pursue
further strategic acquisitions.
ACQUISITION OF CHAS. LEVY CIRCULATING CO. LLC
On May 10, 2005, the Company and Chas. Levy Company LLC entered into a Unit
Purchase Agreement (the "Purchase Agreement"). Under the terms of the Purchase
Agreement, the Company purchased all of the issued and outstanding membership
interests in Chas. Levy Circulating Co. LLC ("Levy") from Chas. Levy Company LLC
for a purchase price of approximately $30 million, subject to adjustment based
on Levy's net worth as of the closing date of the transaction. Chas. Levy
Company LLC was the sole member of Levy.
On May 10, 2005, as contemplated by the terms of the Purchase Agreement, the
Company and Levy Home Entertainment LLC ("LHE") entered into a Distribution and
Supply Agreement (the "Distribution Agreement"). Under the terms of the
Distribution Agreement, LHE appointed the Company as its sole and exclusive
subdistributor of book products to all supermarkets (excluding supermarkets
combined with general merchandise stores), drug stores, convenience stores,
newsstands and terminals within the geographic territory in which the Company
currently distributes DVDs, CDs and/or magazines. The initial term of the
Distribution Agreement begins on May 10, 2005 and expires on June 30, 2015. The
parties may renew the agreement thereafter for successive one year periods.
SOURCE INTERLINK BUSINESS
Our business provides supply chain management and/or related value-added
products and services to most national regional retailers, magazine publishers
and other providers of home entertainment content.
Our clients include:
- Mainstream retailers, such as The Kroger Company, Target
Corporation, Walgreen Company, Ahold USA, Inc., Kmart
Corporation, Sears, Roebuck & Co., and Meijers;
- Specialty retailers, such as Barnes & Noble, Inc., Borders
Group, Inc., The Musicland Group, Inc., Hastings
Entertainment, Inc., Fry's Electronics, Inc. and Circuit City
Stores, Inc.; and
- e-commerce retailers, such as amazon.com, barnesandnoble.com,
circuitcity.com and bestbuy.com;
18
Our suppliers include:
- Record labels, such as Vivendi Universal S.A., Sony BMG Music
Entertainment Company, WEA Distribution and Thorn-EMI;
- Film studios, such as The Walt Disney Company, Time-Warner
Inc., Sony Corp., The News Corporation, Viacom Inc. and
General Electric Company; and,
- Magazine Distributors, such as COMAG Marketing Group, LLC.,
Time Warner Retail Sales & Marketing, Inc., Curtis Circulation
Company and Kable Distribution Services, Inc.;
Our business model is designed to deliver a complete array of products and
value-added services developed to assist retailers and manufacturers of digital
versatile disks (DVDs), audio compact disks (CDs), magazines, confections and
general merchandise in efficiently and effectively marketing their products to
consumers visiting the more than 110,000 store fronts we serve.
Our business consists of four business segments: Magazine Fulfillment, CD and
DVD Fulfillment, In-Store Services 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 26,000
retail stores, 7,300 of which also benefit from our selection
and logistical procurement services.
- Our CD and DVD Fulfillment group was established upon the
acquisition of Alliance Entertainment Corp. effective February
28, 2005. The group provides full-service distribution of
pre-recorded music, videos, video games and related
accessories and merchandise to retailers and other customers
primarily in North America. The group provides product and
commerce solutions to "brick-and-mortar" and e-commerce
retailers, while maintaining trading relationships with major
manufacturers of pre-recorded music, video, and related
products. As part of the traditional distribution services,
and as an integral part of its service offering, the group
also provides consumer-direct fulfillment ("CDF"), and vendor
managed inventory ("VMI") solutions to its customers.
- 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 Shared Services group consists of overhead functions not
allocated to the other operating groups. These functions
include corporate finance, human resource, management
information systems and executive management. Upon completion
of our consolidation of our administrative operations, we
restructured our accounts to separately identify corporate
expenses that are not directly or exclusively attributable to
any of our three main operating groups.
19
REVENUES:
The CD and DVD Fulfillment group derives revenues from:
- selling and distributing pre-recorded music, videos, video games and
related products to retailers;
- providing product and commerce solutions to "brick-and-mortar" and
e-commerce retailers; and
- providing consumer-direct fulfillment and vendor managed inventory
services to its customers.
The Magazine Fulfillment group derives revenues from:
- selling and distributing magazines, including domestic and foreign
titles, to major specialty and mainstream retailers and wholesalers
throughout the United States and Canada;
- exporting domestic titles internationally to foreign wholesalers or
through domestic brokers;
- 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;
- shipping, installing and removing front-end fixtures;
- designing, manufacturing and installing custom wood fixtures
primarily for retailers; and
- providing information and management services relating to magazine
sales to retailers and publishers throughout the United States and
Canada.
COST OF REVENUES
Our cost of revenues for the Magazine Fulfillment and the CD and DVD Fulfillment
groups consists of the costs of products purchased for resale less all
applicable publisher discounts and rebates.
Our cost of revenues for the In-Store Services group 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, certain 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, DVDs
and CDs by third-party freight carriers, primarily Federal Express ground
service and UPS. Freight rates are driven primarily by the weight of the product
being shipped and the distance between origination and destination.
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 and our CD and DVD Fulfillment groups will result in an increase in
fulfillment freight.
20
RELOCATION EXPENSES
The Company completed expansion into the mainstream retail market during the
first quarter of fiscal 2005. The expansion schedule required relocation from
the distribution fulfillment center in Milan, OH to Harrisburg, PA. The Company
did not incur similar costs in the six month period ended July 31, 2005.
21
RESULTS OF OPERATIONS
The following table sets forth, for the periods presented, information relating
to our continuing operations (in thousands):
2005 2004
THREE MONTHS ENDED JULY 31, Amount Margin % Amount Margin %
- --------------------------- ------------- ---------- ------------ ----------
CD AND DVD FULFILLMENT
Revenue $ 208,640 $ - -
Cost of revenue 172,153 - -
Gross profit 36,487 17.5% - -
Operating expense (1) 29,646 - -
------------ ---- ----------- ----
Operating income $ 6,841 3.3% $ - -
MAGAZINE FULFILLMENT
Revenue $ 166,763 $ 65,651
Cost of revenue 130,162 49,242
Gross profit 36,601 21.9% 16,409 25.0%
Operating expense (1) 31,897 11,798
------------ ---- ----------- ----
Operating income $ 4,704 2.8% $ 4,611 6.9%
IN-STORE SERVICES
Revenue $ 18,387 $ 21,207
Cost of revenue 12,486 13,940
Gross profit 5,901 32.1% 7,267 34.3%
Operating expense (1) 2,308 2,239
------------ ---- ----------- ----
Operating income $ 3,593 19.5% $ 5,028 23.7%
OTHER (SHARED SERVICES)
Revenue $ - $ -
Cost of revenue - -
Gross profit - - - -
Operating expense (1) 5,702 3,750
------------ ---- ----------- ----
Operating loss $ (5,702) - $ (3,750) -
TOTAL FROM CONTINUING OPERATIONS
Revenue $ 393,790 $ 86,858
Cost of revenue 314,801 63,182
Gross profit 78,989 20.1% 23,676 27.3%
Operating expense (1) 69,553 17,787
------------ ---- ----------- ----
Operating income $ 9,436 2.4% $ 5,889 6.8%
============ ==== =========== ====
- ----------
(1) Operating expenses include selling, general and administrative expenses,
fulfillment freight, merger and acquisition charges, depreciation and
amortization of intangibles.
22
2005 2004
SIX MONTHS ENDED JULY 31, Amount Margin % Amount Margin %
- ------------------------- ------------- ---------- ------------ ----------
CD AND DVD FULFILLMENT
Revenue $ 357,102 $ -
Cost of revenue 293,289 -
Gross profit 63,813 17.9% - -
Operating expense (1) 49,739 -
------------ ---- ----------- ----
Operating income $ 14,074 3.9% $ - -
MAGAZINE FULFILLMENT
Revenue $ 238,416 $ 131,406
Cost of revenue 182,902 99,604
Gross profit 55,514 23.3% 31,802 24.2%
Operating expense (1) 47,015 23,306
Relocation expense - 1,552
------------ ---- ----------- ----
Operating income $ 8,499 3.6% $ 6,944 5.3%
IN-STORE SERVICES
Revenue $ 32,693 $ 37,633
Cost of revenue 22,486 23,680
Gross profit 10,207 31.2% 13,953 37.1%
Operating expense (1) 4,837 4,516
------------ ---- ----------- ----
Operating income $ 5,370 16.4% $ 9,437 25.1%
OTHER (SHARED SERVICES)
Revenue $ - $ -
Cost of revenue - -
Gross profit - - - -
Operating expense (1) 14,170 7,464
------------ ---- ----------- ----
Operating loss $ (14,170) - $ (7,464) -
TOTAL FROM CONTINUING OPERATIONS
Revenue $ 628,211 $ 169,039
Cost of revenue 498,677 123,284
Gross profit 129,534 20.6% 45,755 27.1%
Operating expense (1) 115,761 35,286
Relocation expenses - 1,552
------------ ---- ----------- ----
Operating income $ 13,773 2.2% $ 8,917 5.3%
============ ==== =========== ====
- ----------
(1) Operating expenses include selling, general and administrative expenses,
fulfillment freight, merger and acquisition charges, depreciation and
amortization of intangibles.
23
THREE MONTHS ENDED JULY 31, 2005, AS COMPARED TO THE THREE MONTHS ENDED JULY 31,
2004
REVENUES
Total revenues for the quarter ended July 31, 2005 increased $306.9 million, or
353.4%, from the prior year same quarter due primarily to the acquisitions of
Alliance Entertainment Corp. and Levy as discussed below.
CD AND DVD FULFILLMENT - On February 28, 2005, we acquired Alliance
Entertainment Corp. Results of operations have been included in our consolidated
financial statements since the date of acquisition. CD and DVD Fulfillment
accounted for approximately 53.0% of our revenues, or $208.6 million, for the
quarter ended July 31, 2005. There were no CD and DVD Fulfillment revenues in
the second quarter of fiscal 2005.
MAGAZINE FULFILLMENT - The group's revenues were $166.8 million, an increase of
$101.1 million or 154.0% as compared to the quarter ended July 31, 2004.
The group's revenues for the three month periods ended July 31 are comprised of
the following components (in thousands):
2005 2004 Change
----------- ---------- -------------
Domestic Specialty $ 56,456 $ 54,149 $ 2,307
Domestic Mainstream 101,789 1,849 99,940
Export 8,518 9,653 (1,135)
----------- ---------- ------------
Total $ 166,763 $ 65,651 $ 101,112
=========== ========== ============
Revenue 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. Revenues
also consists of fees earned for the picking of third party product, return
processing and wastepaper revenue. Domestic mainstream revenues originate from
sales to "mainstream" retailers, which consist of grocery, discount, terminals,
convenience stores and drug stores. The mainstream distribution channel's
revenues include book and magazine distribution. Domestic specialty revenues
originate from magazine sales to "specialty" retailers, which consist of
bookstores, music outlets, office supply stores and computer stores. The
magazine industry in the United States has set-up two distinct distribution
channels to service each of these separate retailer classifications. In May
2005, the group significantly increased its presence in the mainstream market
with the acquisition of Levy, a leading magazine wholesaler based in Chicago, IL
with distribution centers in Chicago, IL, Lancaster, PA, Brainerd, MN, and City
of Industry, CA.
The $101.1 million increase in revenue relates primarily to the $99.9 million
increase in domestic mainstream revenues. The increase was attributable
primarily to the company's marketing efforts to obtain customers in this
distribution channel as well as the acquisitions of Levy and Empire News. The
decrease in the export revenues relates primarily to the timing of the printing
of certain publisher clients export copies, which impacts when the copy is able
to deliver them to its customers and recognize revenues.
Sales efficiency expressed as a percentage of net distribution to gross
distribution was 45.5%, 37.6% and 36.9% for the specialty, mainstream and export
groups respectively. The prior year comparable period efficiencies were 46.2%,
44.4% and 41.6%. The mainstream distribution channel's sales include book and
magazine distribution. Books generally remain on sale longer then magazines and
as a result have higher sales efficiencies. The mainstream distribution channel
generally experience magazine sales efficiencies lower than sales to the
specialty distribution channel.
24
IN-STORE SERVICES - Our In-Store Services group revenues were $18.4 million, a
decrease of $2.8 million or 13.3% as compared to the quarter ended July 31,
2004.
The group's revenues are comprised of the following components (in millions):
Three months ended July 31, 2005 2004 Change
- ---------------------------- ----------- ----------- -------------
Claim filing and information $ 4,333 $ 4,042 $ 291
Front end wire and services 6,098 9,413 (3,315)
Wood 7,956 7,752 204
----------- ----------- ------------
Total $ 18,387 $ 21,207 $ (2,820)
=========== =========== ============
Our claim filing revenues are recognized at the time the claim is paid.
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 thereby decreasing or delaying the revenue recognized on the front
end wire programs.
Wood revenues increased $0.2 million, an increase of 2.6% over the quarter
ending July 31, 2004.
GROSS PROFIT
Gross profit for the period increased $55.3 million or 233.6%, over the second
quarter of fiscal 2005 primarily due to the acquisitions of Alliance
Entertainment Corp. and Levy.
Overall gross profit margins decreased 7.2 percentage points in the current
period over the comparable period of the prior fiscal year. Margins decreased
overall due to the acquisition of Alliance Entertainment Corp. in the current
quarter as the gross profit margins on CDs and DVDs are generally lower than the
remainder of our product mix while they represent a significant percentage of
our sales.
CD AND DVD FULFILLMENT - Gross profit was $36.5 million with a gross margin of
17.5%. We did not distribute CDs and DVDs during the second quarter of fiscal
2005.
MAGAZINE FULFILLMENT - The group's gross profit was $36.6 million, an increase
of $20.2 million or 123.1%, compared to the quarter ended July 31, 2004. Gross
profit margin decreased from 25.0% to 21.9%.
The decrease in gross profit margins is attributable to the change in sales mix
due to the increase in revenues in the mainstream distribution channel. The
mainstream distribution channel generally has lower gross margins then the
specialty distribution channel due to certain publisher rebates that are
available to the specialty distribution channel that are not available in the
domestic distribution channel. The gross margins were 27.3% and 19.4% for the
specialty and mainstream groups, respectively.
IN-STORE SERVICES - Gross profit in our In-Store Services group decreased $1.4
million or 18.8%. The decrease in gross profit and gross profit margin is being
driven by the decrease in sales volume and increase in pricing pressure in the
front end wire and services offset slightly by increase in claiming revenues and
wood revenues.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses, including depreciation and
amortization, for the quarter ended July 31, 2005 increased $38.2 million or
293.0%, compared to the prior fiscal year comparable quarter. Selling, general,
and administrative expenses as a percent of revenues decreased from 15% to 13%.
CD AND DVD FULFILLMENT - The CD and DVD Fulfillment group's selling, general,
and administrative expenses were $22.7 million, of which approximately $1.6
million relates to amortization of intangibles. We did not distribute CDs and
DVDs during the second quarter of fiscal 2005.
MAGAZINE FULFILLMENT - The group's selling, general and administrative expenses
include the costs of operating the group's distribution centers, the in-store
merchandising field force and the backroom operations. Selling, general and
administrative expenses increased $13.5 million, or 191.0%, from $7.0 million to
$20.5 million. The increase relates primarily to the expansion of the group's
25
mainstream distribution infrastructure. Expenses as a percentage of revenues
increased from 10.7% to 12.3%. The increase relates primarily to the mainstream
distribution in-store merchandising field force, which is required to support
distribution to the majority of mainstream retailer accounts.
IN-STORE SERVICES - The selling, general, and administrative expenses of the
In-Store Services group remained flat at approximately $2.3 million compared to
the second quarter of fiscal 2005.
SHARED SERVICES - The selling, general, and administrative expenses of Shared
Services increased $2.0 million or 52.1%. The overall increase is primarily due
to incurring additional expenses to properly manage the expanded role of shared
services after the acquisitions of Alliance Entertainment Corp. and Levy. As
noted above, as a percentage of sales, shared services costs decreased from 4.3
% to 1.5 %.
SIX MONTHS ENDED JULY 31, 2005, AS COMPARED TO THE SIX MONTHS ENDED JULY 31,
2004
REVENUES
Total revenues for the six month period ended July 31, 2005 increased $459.2
million, or 271.6%, from the prior year same period due primarily to the
acquisitions of Alliance Entertainment Corp. and Levy as discussed below.
CD AND DVD FULFILLMENT - On February 28, 2005, we acquired Alliance
Entertainment Corp. Results of operations have been included in our consolidated
financial statements since the date of acquisition. CD and DVD Fulfillment
accounted for approximately 56.8% of our revenues, or $357.1 million, for the
six month period ended July 31, 2005. There were no CD and DVD Fulfillment
revenues in the six month period ended July 31, 2004.
MAGAZINE FULFILLMENT - The group's revenues were $238.4 million, an increase of
$107.0 million or 81.4% as compared to the six months ended July 31, 2004.
The group's revenues for the six months ended July 31 are comprised of the
following components (in thousands):
2005 2004 Change
------------ ------------ -------------
Domestic Specialty $ 112,243 $ 108,045 $ 4,198
Domestic Mainstream 109,387 3,206 106,181
Export 16,786 20,155 (3,369)
------------ ------------ ------------
Total $ 238,416 $ 131,406 $ 107,010
============ ============ ============
Revenue 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. Revenues
also consists of fees earned for the picking of third party product, return
processing and wastepaper revenue. Domestic mainstream revenues originate from
sales to "mainstream" retailers, which consist of grocery, discount, terminals,
convenience stores and drug stores. The mainstream distribution channel's
revenues include book and magazine distribution. Domestic specialty revenues
originate from magazine sales to "specialty" retailers, which consist of
bookstores, music outlets, office supply stores and computer stores. The
magazine industry in the United States has set-up two distinct distribution
channels to service each of these separate retailer classifications. In May
2005, the group significantly increased its presence in the mainstream market
with the acquisition of Chas. Levy Circulating Co., a leading magazine
wholesaler based in Chicago, IL with distribution centers in Chicago, IL,
Lancaster, PA, Brainerd, MN, and City of Industry, CA.
The $107.0 million increase in revenue relates primarily to the $106.2 million
increase in domestic mainstream revenues. The increase was attributable
primarily to the company's marketing efforts to obtain customers in this
distribution channel as well as the acquisitions of Chas. Levy and Empire News.
The decrease in the export revenues relates primarily to the timing of the
printing of certain publisher clients export copies, which impacts when the copy
is able to deliver them to its customers and recognize revenues.
Sales efficiency expressed as a percentage of net distribution to gross
distribution was 44.3%, 37.1% and 36.3% for the specialty, mainstream and export
groups respectively. The prior year comparable period efficiencies were 46.1%,
45.3% and 37.5%. The mainstream distribution channel's sales include book and
magazine distribution. The mainstream distribution channel generally experience
magazine sales efficiencies lower than sales to the specialty distribution
channel.
26
IN-STORE SERVICES - Our In-Store Services group revenues were $32.7 million, a
decrease of $4.9 million or 13.1% compared to the six month period ended July
31, 2004.
The group's revenues are comprised of the following components (in millions):
Six months ended July 31, 2005 2004 Change
- ------------------------- ----------- ------------ -------------
Claim filing and information $ 7,877 $ 8,326 $ (449)
Front end wire and services 11,169 17,656 (6,487)
Wood 13,647 11,651 1,996
----------- ------------ ------------
Total $ 32,693 $ 37,633 $ (4,940)
----------- ------------ ------------
Our claim filing revenues are recognized at the time the claim is paid. The
decrease in revenues in the current period relates exclusively to the timing of
the cash payments received on the claims.
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 thereby decreasing or delaying the revenue recognized on the front
end wire programs.
Wood revenues increased $2.0 million, an increase of 17.1% over the six months
ending July 31, 2004. The increase is primarily driven by an increase in the
number of store openings and remodelings performed by our customers.
GROSS PROFIT
Gross profit for the period increased $83.8 million or 183.1%, over the six
month period ended July 31, 2004 primarily due to the acquisitions of Alliance
Entertainment Corp. and Levy.
Overall gross profit margins decreased 6.5 percentage points in the current
period over the comparable period of the prior fiscal year six month period.
Margins decreased overall due to the acquisition of Alliance Entertainment Corp.
in the prior quarter as the gross profit margins on CDs and DVDs are generally
lower than the remainder of our product mix while they represent a significant
percentage of our sales.
CD AND DVD FULFILLMENT - Gross profit was $63.8 million with a gross margin of
17.9%. We did not distribute CDs and DVDs during the first six months of fiscal
2005.
MAGAZINE FULFILLMENT - The group's gross profit was $55.5 million, an increase
of $23.7 million or 74.5%, as compared to the comparable period of the prior
year. Gross profit margin decreased from 24.2% to 23.3%.
The decrease in gross profit margins is attributable to the change in sales mix
due to the increase in revenues in the mainstream distribution channel. The
mainstream distribution channel generally has lower gross margins then the
specialty distribution channel due to certain publisher rebates that are
available to the specialty distribution channel that are not available in the
domestic distribution channel. The gross margins were 27.5% and 20.8% for the
specialty and mainstream groups, respectively.
IN-STORE SERVICES - Gross profit in our In-Store Services group decreased $3.7
million or 26.9%. The decrease in gross profit and gross profit margin is being
driven by the decrease in sales volume and increase in pricing pressure in the
front end wire and services coupled with the decrease in claiming revenues due
to timing of cash collections in the six month period ended July 31, 2005 as
compared to the six month period ended July 31, 2004.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses, including depreciation and
amortization, for the six months ended July 31, 2005 increased $58.3 million or
227.3%, compared to the prior fiscal year comparable six months. Selling,
general, and administrative expenses as a percent of revenues declined from
15.2% to 13.4%.
27
CD AND DVD FULFILLMENT - The CD and DVD Fulfillment group's selling, general,
and administrative expenses were $38.1 million, of which approximately $2.8
million relates to amortization of intangibles. We did not distribute CDs and
DVDs during the six month period of fiscal 2005.
THE MAGAZINE FULFILLMENT - The group's selling, general and administrative
expenses include the costs of operating the group's distribution centers, the
in-store merchandising field force and the backroom operations. Selling, general
and administrative expenses increased $16.3 million, or 118.8%, from $13.7
million to $29.9 million. The increased relates primarily to the expansion of
the group's mainstream distribution infrastructure. Expenses as a percentage of
revenues increased from 10.4% to 12.5%. The increase relates primarily to the
mainstream distribution in-store merchandising field force, which is required to
support distribution to the majority of mainstream retailer accounts.
IN-STORE SERVICES - The selling, general, and administrative expenses of the
In-Store Services group remained flat at approximately $4.6 million compared to
the six month period of fiscal 2005.
SHARED SERVICES - The selling, general, and administrative expenses of Shared
Services increased $3.8 million or 51.4%. The overall increase is primarily due
to incurring additional expenses to properly manage the expanded role of shared
services after the acquisitions of Alliance Entertainment Corp. and Levy. As
noted above, as a percentage of sales, shared services costs decreased from 4.4%
to 1.8 %, excluding the merger and acquisition charges related to the Alliance
acquisition.
FULFILLMENT FREIGHT
Fulfillment freight represents the outbound freight costs of distribution. It
consists primarily of the costs, including payroll, of operating the fleet of
trucks that deliver the majority of the books and magazines in the mainstream
distribution channel, as well as payments to third party carriers to provide
delivery service directly from our distribution centers to our customers' retail
stores.
Fulfillment freight expenses increased $13.6 million or 285.7%, compared to the
three months ended July 31, 2004 and $19.1 million or 197.9% compared to the six
months ended July 31, 2004. The CD and DVD Fulfillment group incurred $6.9
million during the quarter ended July 31, 2005 and $11.6 million for the six
months ended July 31, 2005 and we did not distribute CDs and DVDs during the
quarter or six month period ended July 31, 2004. The Magazine Fulfillment
group's freight expense increased $6.7 million, or 139.9%, from $4.8 million to
$11.4 million for the three month period ended July 31, 2005. Freight expense as
a percent of gross domestic distribution decreased from 3.9% to 2.9%. The
decrease is attributable to the expansion of our distribution into the
mainstream distribution channel. The Magazine Fulfillment group's freight
expense increased $8.2 million, or 85.5%, from $9.6 million to $17.9 million for
the six month period ended July 31, 2005. Freight expense as a percent of gross
domestic distribution decreased from 4.0% to 3.2%. The decrease is attributable
to the expansion of our distribution into the mainstream distribution channel.
RELOCATION EXPENSES
During the quarter ended July 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 in the quarter. Relocation expenses recorded
in the quarter ended July 31, 2004, including a lease termination charge and the
transfer of employees and equipment, were approximately $1.6 million.
MERGER AND ACQUISITION CHARGES
Merger charges related to acquisitions recorded as expenses by the Company
through July 31, 2005 totaled $3.1 million. These expenses represented severance
and personnel-related charges, charges to exit certain merchandiser contracts
and a success fee paid to certain Company executives. These expenses were not
capitalized as they did not represent costs that provide future economic
benefits to the Company.
OPERATING INCOME
Operating income for the quarter ended July 31, 2005 increased $3.5 million or
60.2%, compared to the same quarter in the prior fiscal year due to the factors
described above.
28
Operating income for the six months ended July 31, 2005 increased $4.9 million
or 54.5%, compared to the six months ended July 31, 2004 due to the factors
described above.
Operating profit margins decreased from 6.8% for the quarter ended July 31, 2004
to 2.4% for the quarter ended July 31, 2005 and decreased from 5.3% for the six
month period ended July 31, 2004 to 2.2% for the six month period ended July 31,
2005. The decrease was primarily due to the acquisition of Alliance which
accounted for approximately 53.0% of our revenues in the quarter ended July 31,
2005, and had an operating profit margin of approximately 3.3%. In addition, the
Magazine Fulfillment group had operating profit margins of 7.0% and 6.5% for the
quarter and six month period ended July 31, 2004, excluding relocation charges
and these margins decreased to 2.8% and 3.6% for the quarter and six month
period ended July 31, 2005, respectively, due to the acquisition of Levy, which
historically had lower operating margins than our specialty distribution group.
INTEREST EXPENSE
Interest expense includes the interest and fees on our significant debt
instruments and outstanding letters of credit.
Interest expense increased $1.6 million or 1306.5% from the quarter ended July
31, 2004 and $2.0 million or 305.8% compared to the six month period ended July
31, 2004. Interest expense increase from the prior year quarter and six month
period are due to significantly lower borrowings in the prior fiscal year as a
result of the raising of proceeds from the sale of 3.8 million shares of common
stock. In addition, the Company acquired Levy in the quarter ended July 31, 2005
for approximately $30.0 million and funded working capital of approximately
$14.0 million which also contributed to the higher interest charges in the
quarter and six month periods.
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 six months ended July 31, 2004, the Company recorded a charge of
approximately $1.5 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 47.8% and 31.7% for the quarters ended July
31, 2005 and 2004, respectively.
The effective income tax rates were 49.2% and 32.0% for the six months ended
July 31, 2005 and 2004, respectively.
The difference between the statutory rate and effective tax rates for the
quarter and six month period ended July 31, 2005 primarily relates to the
amortization of the intangible assets acquired in the Alliance Entertainment
Corp. transaction not being deductible for tax purposes.
The difference between the statutory rate and effective tax rates for the
quarter and six month period ended July 31, 2004 relates primarily to the
realization of a portion of the net operating loss carryforward acquired with
our acquisition of Interlink.
DISCONTINUED OPERATION
In November 2004, the Company sold and disposed of its secondary wholesale
distribution operation for $1.4 million, in order to focus more fully on its
domestic and export distribution. All rights owned under the secondary wholesale
distribution contracts were assigned, delivered, conveyed and transferred to the
buyer, an unrelated third party. All assets and liabilities of the secondary
wholesale distribution operation were not assumed by the buyer. The Company
recognized a gain on sale of this business of $1.4 million ($0.8 net of tax) in
the fourth quarter of fiscal year 2005. In the second quarter of fiscal 2006,
the Company wrote off certain accounts receivable totaling $1.4 million, net of
tax.
29
The following amounts related to the Company's discontinued operation have been
segregated from continuing operations and reflected as discontinued operations
(in thousands):
Three months ended July 31, Six months ended July 31,
---------------------------- -----------------------------
2005 2004 2005 2004
------------ ----------- ----------- ------------
Revenues $ - $ 4,583 $ - $ 8,089
----------- ---------- ---------- -----------
(Loss) income before taxes (2,410) 123 (2,410) (102)
Income tax benefit (expense) 964 (49) 964 41
=========== ========== ========== ===========
(Loss) income from discontinued operation, net of tax $ (1,446) $ 74 $ (1,446) $ (61)
=========== ========== ========== ===========
LIQUIDITY AND CAPITAL RESOURCES
OVERVIEW
Our primary sources of cash include receipts from our customers, borrowings
under our credit facilities and, from time to time, the proceeds from the sale
of common stock.
Our primary cash requirements for the CD and DVD Fulfillment group and the
Magazine Fulfillment group consist of the cost of home entertainment products
and freight, labor and facility expenses 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 wood and wire displays, the cost of labor incurred in providing our
claiming, design and information services, and cash advances to fund 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 rights to
collect the claim. We collect the claims when paid by publishers for our own
account.
Our primary cash requirements for the Shared Services group consist of salaries,
professional fees and insurance costs not allocated to specific operating
groups.
The following table presents a summary of our significant obligations and
commitments to make future payments under debt obligations and lease agreements
as of July 31, 2005 (in thousands):
Payments Due by Period
--------------------------------------------------------------------------------
Less
Than 1-3 3-5 After 5
Total 1 year Years Years Years
--------------- -------------- ----------- ------------ -----------
Debt obligations $ 101,490 4,601 12,757 4,583 79,549
Operating leases 61,201 6,556 19,185 14,660 20,800
------------ ------ ------ ------ -------
Total contractual cash obligations $ 162,691 11,157 31,942 19,243 100,349
============ ====== ====== ====== =======
30
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 3-5 After 5
Total 1 year Years Years Years
Financial standby letters of credit $ 6,435 6,435 $ - $ - $ -
----------- ----- -------- -------- ------
Total commercial commitments 6,435 6,435 - - -
=========== ===== ======== ======== ======
OPERATING CASH FLOW
Net cash provided by (used in) operating activities was $15.4 and ($1.9) million
for the six months ended July 31, 2005 and 2004, respectively.
Operating cash flows for the six months ended July 31, 2005 were comprised of
net income of $4.3 million, plus non-cash charges including depreciation and
amortization of $8.2 million and provisions for losses on accounts receivable of
$1.7 million, a tax benefit received on stock options exercised of $1.1 million
and an increase of $0.1 million in deferred revenue. An increase in accounts
payable and other liabilities of $11.4 million and a decrease in other assets of
$4.7 million also provided cash for the six month period ended July 31, 2005.
These cash providing activities were offset by an increase in inventories of
$15.2 million, and an increase in accounts receivable of $1.0 million.
The increase in accounts receivable for the six months ended July 31, 2005 was
primarily due to a increase in accounts receivable of $11.5 million from the
Magazine Fulfillment group as a result of an increase in our mainstream
distribution business as well as certain negotiated collection terms. The
increase was offset by CD and DVD Fulfillment group decrease of $9.5 million due
to collections subsequent to the date of acquisition. In addition, the In-Store
Services division decreased accounts receivable by $6.3 million due to
significant cash collections in the current period and lower sales volume. This
decrease is consistent with prior first quarter activity.
The increase in accounts payable and other current and non-current liabilities
in the current period of $11.4 million relates primarily to the timing of vendor
payments in the current period as compared to the quarter ended January 31,
2005.
The increase in inventories of $15.2 million for the six months ended July 31,
2005 was primarily due to the acquisition of the CD and DVD Fulfillment group on
February 28, 2005, as approximately $11.3 million of the increase was
attributable to their purchases subsequent to the date of acquisition.
Operating cash flows for the six months ended July 31, 2004 were primarily from
net income ($4.6 million), plus non-cash charges including depreciation and
amortization ($2.6 million) and provisions for losses on accounts receivable
($0.4 million), a write off of deferred financing costs and original issue
discount ($1.5 million), a decrease in inventories, a decrease in other assets
and an increase in accounts payable accrued expenses ($1.5 million, $0.3 million
and $3.0 million, respectively). These cash providing activities were offset by
an increase in accounts receivable ($15.2 million).
The increase in accounts receivable for the six months ended July 31, 2004 was
primarily due to the increased revenues of the Magazine Fulfillment group
coupled with a decrease in the sales returns reserve for the six month period
ended July 31, 2004 ($10.2 million). Increased revenues of approximately $4.0
million over the first quarter in the Wood Division increased accounts
receivable by approximately $3.0 million for the six months ended July 31, 2004.
In addition, the In-Store Division had an increase in accounts receivable of
approximately $2.0 million due primarily to the timing of an advanced payment to
a retailer.
The increase in accounts payable and accrued expenses in the current period of
$3.0 million relates primarily to the timing of vendor payments in the current
period as compared to the quarter ended January 31, 2004.
31
INVESTING CASH FLOW
Net cash (used in) provided by investing activities was $(43.0) and $1.7 million
for the six month periods ended July 31, 2005 and 2004, respectively.
For the six months ended July 31, 2005, cash used in investing activities was
reduced by capital expenditures of $6.1 million, which was partially offset by
$1.5 million in proceeds from the sale of equipment. Our advance pay program
used $8.0 million in the current period. We also invested $2.3 million for the
rights to distribute certain titles over a period of three to fifteen years. As
part of the acquisition of the CD and DVD Fulfillment group, we acquired cash of
$16.9 million after direct acquisition costs; and finally, the Company utilized
approximately $30.0 million in the purchase of Chas. Levy Circulating Co. LLC.
In addition, approximately $19.3 million was also provided on the date of
acquisition to seller to repay all outstanding intercompany debt of Levy.
For the six months ended July 31, 2004, cash provided by investing activities
was reduced by capital expenditures of $3.2 million, which in part related to
our expansion of our distribution facility in Harrisburg, Pennsylvania. Our
advance pay program generated net cash flow of $3.3 million in the period ended
July 31, 2004. 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 $3.1 million of the advances
during the six months ended July 31, 2004. Additionally, the Company made a $1.5
million payment under the magazine import agreement, which gives the Company
rights to distribute domestically a group of foreign magazine titles.
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 wood, wire and services business and the payment
cycles of the CD and DVD and magazine distribution businesses. Because the
magazine distribution business and advance pay program cash requirements peak at
our fiscal quarter ends, the reported bank debt levels usually are at their
highest 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. Alliance has historically generated
approximately 33% of its total net sales in the fourth calendar quarter
coinciding with the holiday shopping season and therefore should have greater
borrowings in the third quarter to finance the buildup of inventory.
The front end wood, 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 programs are generally collected within 180 days. The Company is
usually required to tender payment on the costs of these programs within a
shorter period. As a result, our funding requirements peak in the second and
third fiscal quarters when we manufacture the fixtures and decrease
significantly in the fourth and first fiscal quarters as the related receivable
are collected.
Net cash provided by financing activities was $30.4 and $3.7 million for the six
months ended July 31, 2005 and 2004, respectively.
Financing activities in the first six months of fiscal year 2006 consisted of
borrowings under the credit facilities of $55.2 million. These funds were offset
by repayments of $19.3 million in debt and capital leases, approximately $8.8
million of which relates to the repayment of the Wells Fargo Foothill term loan
in connection with the modification of the revolving credit facility, and a
decrease of $7.5 million in checks issued and outstanding at July 31, 2005.
Finally, the exercise of employee stock options in the quarter generated
approximately $3.1 million.
32
Financing activities in the first six 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 term loan, the Hilco Capital note
payable and the notes payable to former owners ($20.7 million) as well the net
pay down of the revolving credit facility ($9.8 million). Additional payments on
note payables were made of approximately $0.8 million. In addition, the cash
provided by the activities noted above were offset by an $8.8 million decrease
in checks issued and outstanding at July 31, 2004. Finally, the exercise of
employee stock options in the period generated approximately $3.3 million.
DEBT
At July 31, 2005, our total debt obligations were $101.5 million, excluding
outstanding letters of credit. Debt consists primarily of amounts owed under a
revolving credit facility, various notes payable related to the acquisition of
magazine import and export businesses, and equipment loans.
On February 28, 2005, the Company modified its existing credit facility with
Wells Fargo Foothill ("WFF") as a result of its acquisition of Alliance
Entertainment Corp. WFF, as arranger and administrative agent for each of the
lenders that may become a participant in such arrangement and their successors
("Lenders") will make revolving loans to us and our subsidiaries of up to $250
million and provide for the issuance of letters of credit. The terms and
conditions of the arrangement are governed primarily by the Amended and Restated
Loan Agreement dated February 28, 2005 by and among us, our subsidiaries, and
WFF.
Outstanding borrowings bear interest at a variable annual rate equal to the
prime rate announced by Wells Fargo Bank, National Association's San Francisco
office, plus a margin of between 0.0% and 1.00% (applicable margin was 0.0% at
July 31, 2005) based upon a ratio of the Company's EBITDA to interest expense
("Interest Coverage Ratio"). At July 31, 2005 the prime rate was 6.25%. We also
have the option of selecting up to five traunches of at least $1 million each to
bear interest at LIBOR plus a margin of between 2.00% and 3.00% based upon our
Interest Coverage Ratio. The Company has three LIBOR contracts outstanding at
July 31, 2005 (expiring September 2005) and bears interest at a weighted average
rate of approximately 5.55%. To secure repayment of the borrowings and other
obligations of ours to the Lenders, we and our subsidiaries granted a security
interest in all of the personal property assets to WFF, for the benefit of the
Lenders. These loans mature on October 31, 2010.
Under the credit facility, 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. The Company was in compliance with these
ratios at July 31, 2005.
Availability under the facility is limited by the Company's borrowing base
calculation, as defined in the agreement. The calculation resulted in excess
availability, after consideration of outstanding letters of credit, of $75.0
million at July 31, 2005. We believe this revolving credit facility will
provide the Company with adequate liquidity to fund operations over the next
twelve to eighteen months.
Through the acquisition of Levy, the Company assumed four notes payable with
suppliers (the "Supplier Notes") totaling $14.0 million. The maturity dates of
the supplier notes range between March 2007 and August 2014 and bear interest at
5%. Principal repayments range from $1.0 to $2.0 million per fiscal year with
$2.1 million and $1.9 million due to be repaid in fiscal year 2006 and 2007,
respectively. The total principal balance of the supplier notes as of July 31,
2005 is $14.0 million.
Through the acquisition of Alliance, the Company entered into a loan agreement
with SunTrust Leasing Corporation (the "SunTrust Loan") for the purchase of
equipment to be used at various locations. A credit line of $6.8 million was
approved under the SunTrust Loan, with repayment terms for five promissory notes
ranging from three to five years. The total principal balance of the SunTrust
Loan outstanding as of July 31, 2005 was $3.8 million.
OFF-BALANCE SHEET ARRANGEMENTS
We do not engage in transactions or arrangements with unconsolidated or other
special purpose entities.
33
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our primary market risks include fluctuations in interest rates and exchange
rate variability.
The amended revolving credit facility with Wells Fargo Foothill had an
outstanding principal balance of approximately $75.0 million at July 31, 2005.
Outstanding borrowings bear interest at a variable annual rate equal to the
prime rate announced by Wells Fargo Bank, National Association's San Francisco
office, plus a margin of between 0.0% and 1.00% (applicable margin was 0.0% at
July 31, 2005) based upon a ratio of the Company's EBITDA to interest expense
("Interest Coverage Ratio"). At July 31, 2005 the prime rate was 6.25%. We also
have the option of selecting up to five traunches of at least $1 million each to
bear interest at LIBOR plus a margin of between 2.00% and 3.00% based upon our
Interest Coverage Ratio. The Company has three LIBOR contracts outstanding at
July 31, 2005 (expiring September 2005) and bears interest at a weighted average
rate of 5.55%. To secure repayment of the borrowings and other obligations of
ours to the Lenders, we and our subsidiaries granted a security interest in all
of the personal property assets to WFF, for the benefit of the Lenders. These
loans mature on October 31, 2010.
As a result of the above, our primary market risks relate to fluctuations in
interest rates. We do not perform any interest rate hedging activities related
to the facility noted above. Therefore, if the prime rate of interest were to
increase one percentage point based on the Company's current borrowings under
its credit facility, interest expense would increase approximately $0.75 million
on an annual basis.
We have exposure to foreign currency fluctuations through our operations in
Canada. These operations accounted for approximately $3.4 million in revenues,
which represented less than 1.0% of our revenues for the six month period ended
July 31, 2005. 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.
Revenues derived from the export of foreign titles (or sales to domestic brokers
who facilitate the export) totaled $16.8 million for the period ended July 31,
2005 or 7.0% 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 by
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 $48.3
million (of a total $550.8 million or 8.8%). Foreign publications are purchased
in both dollars and the local currency of the foreign publisher, primarily Euros
and pounds 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
minimize if we so choose the foreign currency risk. Foreign titles generally
have significantly higher cover prices than comparable domestic titles, 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.
34
ITEM 4. CONTROLS AND PROCEDURES
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 principal
executive officer and principal 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.
CONCLUSIONS
Based on this evaluation, our chief executive officer and our chief financial
officer, have concluded that, subject to the limitations noted above, as of the
end of the period covered by this report, our disclosure controls and procedures
were effective to ensure that information we are required to disclose in reports
that we file or submit under the Securities Exchange Act of 1934 is recorded,
processed, summarized and reported within the time periods specified in
Securities and Exchange Commission rules and forms and include controls and
procedures designed to ensure that information required to be disclosed
35
by the Company in such reports is accumulated and communicated to the Company's
management, including the Chief Executive Officer and the Chief Financial
Officer, as appropriate to allow timely decisions regarding required disclosure.
There were no changes in the Company's internal controls over financial
reporting (as defined in Rule (13a-15(f) under the Securities Exchange Act of
1934) that occurred during the fiscal quarter ended July 31, 2005 that have
materially affected, or are reasonably likely to materially affect these
controls.
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
(a) The Annual Meeting of the Shareholders of the Company was held on July
12, 2005. Of the 48,310,435 shares entitled to vote at such meeting,
42,079,636 shares were present at the meeting in person or by proxy.
(b) Each of the management nominees for election as Class I directors was
duly elected to serve an additional term of three years expiring in 2008.
These individuals joined the directors S. Leslie Flegel, James R. Gillis,
A. Clinton Allen, Gray Davis, Aron S. Katzman, Allan R. Lyons Michael R.
Duckworth, and Ariel Z. Emanuel whose terms of office continued after the
Company's 2005 Annual Meeting of Shareholders. The number of shares voted
for and against/withheld were as follows:
Against/
For Withheld
------------- ---------------
David R. Jessick 40,967,373 1,112,263
Gregory Mays 41,022,559 1,057,077
George A, Schnug 41,423,199 656,437
ITEM 5. OTHER INFORMATION
Not Applicable.
ITEM 6. EXHIBITS
(a) Exhibits.
See Exhibit Index
36
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: September 09, 2005
SOURCE INTERLINK COMPANIES, INC.
/s/ Marc Fierman
---------------------------------
Marc Fierman
Chief Financial Officer
37
EXHIBIT INDEX
Exhibit
Number Description
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 Certifications of Principal Executive Officer
32.2 Section 1350 Certifications of Principal Financial Officer
38