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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended July 31, 2006
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from __________ to ________
Commission file number 001-13437
[SOURCE INTERLINK COMPANIES LOGO]
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 Identification No.)
incorporation or organization)
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)
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 from the past 90 days.
[X] Yes [ ] No
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerate filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act. (Check one):
[ ] Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act. (Check one)
[ ] Yes [X] No
As of September 1, 2006, there were
51,914,012 shares of the Company's common stock outstanding.
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TABLE OF CONTENTS
PAGE
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PART I - FINANCIAL INFORMATION
ITEM 1. Financial statements. 3
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. 22
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk. 40
ITEM 4. Controls and Procedures. 41
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings. 43
ITEM 1A. Risk Factors. 43
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds. 43
ITEM 3. Defaults upon Senior Securities. 43
ITEM 4. Submission of Matters to a Vote of Security Holders. 43
ITEM 5. Other Information. 43
ITEM 6. Exhibits. 43
Table of Contents
PART I - FINANCIAL INFORMATION
Item 1. financial statements.
INDEX OF FINANCIAL STATEMENTS
PAGE
----
Consolidated Balance Sheets as of July 31, 2006 (unaudited) and January 31, 2006. 4
Consolidated Statements of Income for the three and six months ended July 31, 2006 and 2005 (unaudited). 6
Consolidated Statement of Stockholders' Equity for the six months ended July 31, 2006 (unaudited). 7
Consolidated Statements of Cash Flows for the six months ended July 31, 2006 and 2005 (unaudited). 8
Notes to Consolidated Financial Statements 9
Page 3 of 45
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
July 31,
2006 January 31,
(unaudited) 2006
----------- -----------
ASSETS
Current assets
Cash $ 2,397 $ 23,239
Trade receivables, net 118,814 129,782
Purchased claims receivable 10,623 9,922
Inventories 209,802 198,483
Income tax receivable 438 2,180
Deferred tax asset 18,963 16,403
Other 7,166 6,058
----------- -----------
Total current assets 368,203 386,067
----------- -----------
Property, plants and equipment 96,565 89,971
Less accumulated depreciation and amortization (26,666) (23,255)
----------- -----------
Net property, plants and equipment 69,899 66,716
----------- -----------
Other assets
Goodwill, net 429,119 302,293
Intangibles, net 127,110 118,988
Other 9,293 10,408
----------- -----------
Total other assets 565,522 431,689
----------- -----------
Total assets $ 1,003,624 $ 884,472
=========== ===========
Page 4 of 45
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED BALANCE SHEETS (CONCLUDED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
July 31,
2006 January 31,
(unaudited) 2006
----------- -----------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable and accrued expenses (net of allowance for returns of
$168,234 and $167,423 at July 31, 2006 and January 31, 2006,
respectively) $ 317,601 $ 321,074
Deferred revenue 2,374 3,226
Current portion of obligations under capital leases 852 476
Current maturities of debt 18,335 6,508
----------- -----------
Total current liabilities 339,162 331,284
Deferred tax liability 36,531 4,526
Obligations under capital leases 1,502 1,118
Debt, less current maturities 151,055 80,727
Other 6,534 7,224
----------- -----------
Total liabilities 534,784 424,879
----------- -----------
Commitments and contingencies
Stockholders' equity
Contributed capital:
Preferred stock, $0.01 par (2,000 shares authorized; none issued) -- --
Common stock, $0.01 par (100,000 shares authorized; 51,910 and 51,704
shares issued) 519 517
Additional paid-in-capital 469,308 467,543
----------- -----------
Total contributed capital 469,827 468,060
Accumulated deficit (3,464) (10,817)
Accumulated other comprehensive income:
Foreign currency translation 2,477 2,350
----------- -----------
Total stockholders' equity 468,840 459,593
----------- -----------
Total liabilities and stockholders' equity $ 1,003,624 $ 884,472
=========== ===========
See accompanying notes to Consolidated Financial Statements.
Page 5 of 45
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
Three months ended Six months ended
July 31, July 31,
------------------------ --------------------------
2006 2005 2006 2005
---------- ---------- ----------- -----------
Revenues $ 441,507 $ 393,790 $ 896,107 $ 628,211
Cost of revenues (including depreciation of
$263, $306, $541, and $596, respectively) 345,667 314,801 710,327 498,677
---------- ---------- ----------- -----------
Gross profit 95,840 78,989 185,780 129,534
Selling, general and administrative expense 54,427 46,958 108,747 76,633
Fulfillment freight 25,092 18,354 47,027 28,690
Depreciation and amortization 6,012 4,241 11,817 7,344
Merger and acquisition charges -- -- -- 3,094
Relocation expense 715 -- 715 --
Impairment of land and building held for sale -- -- 529 --
---------- ---------- ----------- -----------
Operating income 9,594 9,436 16,945 13,773
---------- ---------- ----------- -----------
Other income (expense):
Interest expense (including amortization of
deferred financing fees of $150, $168, $306,
and $302, respectively) (2,869) (1,744) (5,137) (2,678)
Interest income 44 44 112 90
Other 56 61 70 135
---------- ---------- ----------- -----------
Total other expense (2,769) (1,639) (4,955) (2,453)
---------- ---------- ----------- -----------
Income from continuing operations, before income taxes 6,825 7,797 11,990 11,320
Income tax expense 2,731 3,721 4,637 5,573
---------- ---------- ----------- -----------
Income from continuing operations 4,094 4,076 7,353 5,747
Loss from discontinued operations, net of tax -- (1,446) -- (1,446)
---------- ---------- ----------- -----------
Net income $ 4,094 $ 2,630 $ 7,353 $ 4,301
========== ========== =========== ===========
Earnings per share - basic:
Continuing operations $ 0.08 $ 0.08 $ 0.14 $ 0.12
Discontinued operations -- (0.03) -- (0.03)
---------- ---------- ----------- -----------
Total $ 0.08 $ 0.05 $ 0.14 $ 0.09
========== ========== =========== ===========
Earnings per share - diluted:
Continuing operations $ 0.08 $ 0.08 $ 0.14 $ 0.12
Discontinued operations -- (0.03) -- (0.03)
---------- ---------- ----------- -----------
Total $ 0.08 $ 0.05 $ 0.14 $ 0.09
========== ========== =========== ===========
Weighted average common shares outstanding - basic 51,811 51,140 51,760 46,800
Weighted average common shares outstanding - diluted 53,291 52,960 53,223 48,751
See accompanying notes to Consolidated Financial Statements.
Page 6 of 45
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)
(UNAUDITED)
Accumulated
Common Stock Other Total
-------------- Additional Accumulated Comprehensive Stockholders'
Shares Amount Paid-in Capital Deficit Income (Loss) Equity
------ ------ ---------------- ----------- ------------- -------------
Balance, January 31, 2006 51,704 $ 517 $ 467,543 $ (10,817) $ 2,350 $ 459,593
Net income -- -- -- 7,353 -- 7,353
Foreign currency translation -- -- -- -- 127 127
------ ------ ---------------- ----------- ----------- ----------
Comprehensive income -- -- -- 7,353 127 7,480
------ ------ ---------------- ----------- ----------- ----------
Stock compensation expense -- -- 416 -- -- 416
Exercise of stock options and warrants 206 2 1,164 -- -- 1,166
Excess tax benefit from stock options exercised -- -- 185 -- -- 185
------ ------ ---------------- ----------- ----------- ----------
Balance, July 31, 2006 51,910 519 469,308 (3,464) 2,477 468,840
====== ====== ================ =========== =========== ==========
See accompanying notes to Consolidated Financial Statements.
Page 7 of 45
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
Six months ended July 31,
------------------------
2006 2005
---------- ----------
OPERATING ACTIVITIES
Net income $ 7,353 $ 4,301
Adjustments to reconcile net income to net cash used in operating activities:
Depreciation and amortization 12,664 8,242
Provision for losses on accounts receivable 2,214 1,725
Deferred revenue (711) 139
Stock compensation expense 416 --
Excess tax benefit from exercise of stock options 1,164 1,096
Impairment of land and building held for sale 529 --
Other (1,424) (74)
Changes in assets and liabilities (excluding business acquisitions):
Decrease (increase) in accounts receivable 7,427 (981)
Decrease (increase) in inventories 13,713 (15,179)
(Increase) decrease in other current and non-current assets (3,199) 4,665
(Decrease) increase in accounts payable and other liabilities (80,975) 11,445
---------- ---------
Cash used in operating activities (40,829) 15,379
---------- ---------
INVESTMENT ACTIVITIES
Capital expenditures (6,460) (6,120)
Purchase of claims (58,541) (54,280)
Payments received on purchased claims 57,840 46,290
Net cash from Alliance Entertainment Corp. acquisition -- 16,878
Acquisition of Anderson Mid-Atlantic News, LLC, net of cash acquired (13,652) --
Acquisition of Anderson SCN Services, LLC, net of cash acquired (26,081) --
Acquisition of distribution rights -- (2,300)
Acquisition of Chas. Levy Circulating Company, LLC, net of cash acquired -- (44,991)
Proceeds from sale of fixed assets 51 1,480
Other (1,330) --
---------- ---------
Cash used in investing activities (48,173) (43,043)
---------- ---------
FINANCING ACTIVITIES
Decrease in checks issued against revolving credit facilities -- (7,517)
Borrowings under credit facilities 71,905 55,210
Net Payments on notes payable and capital leases (5,096) (19,316)
Proceeds from the issuance of common stock 1,351 3,056
Deferred financing cost -- (1,048)
---------- ---------
Cash provided by financing activities 68,160 30,385,
---------- ---------
(Decrease) increase in cash (20,842) 2,721
Cash, beginning of period 23,239 1,387
---------- ---------
Cash, end of period $ 2,397 $ 4,108
========== =========
See accompanying notes to Consolidated Financial Statements.
Page 8 of 45
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. NATURE OF BUSINESS AND BASIS OF PRESENTATION
Source Interlink Companies, Inc. (the "Company") is a leading marketing,
merchandising and fulfillment company of entertainment products including DVDs,
music CDs, magazines, books and related items. The Company's fully integrated
businesses include:
- Distribution and fulfillment of entertainment products to major
retail chains throughout North America and directly to consumers of
entertainment products ordered through the Internet;
- Import and export of periodicals sold in more than 100 markets
worldwide;
- Coordination of product selection and placement of impulse items
sold at checkout counters;
- Processing and collection of rebate claims as well as management of
sales data obtained at the point-of-purchase; and
- Design, manufacture and installation of wire fixtures and custom
wood displays in major retail chains.
Source Interlink serves approximately 110,000 retail store locations throughout
North America. Supply chain relationships include movie studios, record labels,
magazine and newspaper publishers, confectionary companies and manufacturers of
general merchandise.
The consolidated financial statements included herein have been prepared by the
Company, without audit, pursuant to the rules and regulations of the Securities
and Exchange Commission. In the opinion of the Company's management, all
adjustments (consisting only of normal recurring adjustments and
reclassifications) necessary to present fairly our results of operations and
cash flows for the three and six months ended July 31, 2006 and 2005 and our
financial position as of July 31, 2006, respectively have been made. 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,
2006, as filed with the Securities and Exchange Commission ("SEC") on April 17,
2006.
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.
Page 9 of 45
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
2. BUSINESS COMBINATIONS
ACQUISITION OF ANDERSON MID-ATLANTIC NEWS, LLC
On March 30, 2006, the Company and Anderson News, LLC entered into a Unit
Purchase Agreement pursuant to which the Company purchased all of the issued and
outstanding membership interests of Anderson Mid-Atlantic News, LLC
("Mid-Atlantic") from Anderson News, LLC for a purchase price of approximately
$4.0 million, subject to adjustment based on the negative net worth as of the
closing date of the transaction. In addition, approximately $9.6 million was
also provided on the date of acquisition to Mid-Atlantic to repay a portion of
its outstanding intercompany debt. The remaining outstanding intercompany debt
of Mid-Atlantic was satisfied by issuance of a promissory note totaling $4.1
million. The promissory note will be repaid by the Company over a six month
period that began in June 2006 and bears interest at LIBOR minus one (4.39% at
July 31, 2006). The purchase price and the intercompany debt repayment were
funded from the Company's revolving line of credit.
The total cost of the acquisition was allocated to the assets acquired and
liabilities assumed based on their estimated respective fair values in
accordance with FAS 141, Business Combinations. Goodwill, which is deductible
for tax purposes, recorded in connection with the transaction is estimated to
total $26.9 million. These amounts will be tested at least annually for
impairment in accordance with FAS 142, Goodwill and Other Intangible Assets.
The assets acquired and liabilities assumed in the acquisition were recorded in
the quarter ended April 30, 2006. The acquisition was accounted for by the
purchase method and, accordingly, the results of Mid-Atlantic's operations have
been included in our consolidated statements of income since March 31, 2006. 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 the acquisition of Mid-Atlantic is based on a
preliminary internal valuation study, therefore reported amounts may change
based on finalization which is expected to occur during the third quarter of
fiscal 2007.
The assets acquired and liabilities assumed, based on the preliminary internal
valuation, are summarized below:
(IN THOUSANDS) Amount
- ---------------------------------------- -----------
Cash $ 4
Inventories 7,526
Property and equipment 516
Goodwill 26,946
Intangible assets 4,700
Other assets 63
Accounts payable and accrued liabilities (22,003)
-----------
Total consideration $ 17,752
===========
ACQUISITION OF ANDERSON SCN SERVICES, LLC
On March 30, 2006, the Company and Anderson News, LLC entered into a Unit
Purchase Agreement pursuant to which the Company purchased all of the issued and
outstanding membership interests of Anderson-SCN Services, LLC ("SCN") from
Anderson News, LLC for a purchase price of approximately $9.0 million, subject
to adjustment based on the negative net worth as of the closing date of the
transaction. In addition, approximately $17.0 million was also provided on the
date of acquisition to SCN to repay a portion of its outstanding intercompany
debt. The remaining outstanding intercompany debt of SCN was satisfied by
issuance of a promissory note totaling $10.2
Page 10 of 45
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
million. The promissory note will be repaid by the Company over a six month
period that began in June 2006 and bears interest at LIBOR minus one (4.39% at
July 31, 2006). The purchase price and the intercompany debt repayment were
funded from the revolving line of credit.
The total cost of the acquisition was allocated to the assets acquired and
liabilities assumed based on their estimated respective fair values in
accordance with FAS 141, Business Combinations. Goodwill, which is deductible
for tax purposes, recorded in connection with the transaction is estimated to
total $63.2 million. These amounts will be tested at least annually for
impairment in accordance with FAS 142, Goodwill and Other Intangible Assets.
The assets acquired and liabilities assumed in the acquisition were recorded in
the quarter ended April 30, 2006. The acquisition was accounted for by the
purchase method and, accordingly, the results of SCN's operations have been
included in our consolidated statements of income since March 31, 2006. 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 the acquisition of SCN is based on a preliminary
internal valuation study, therefore reported amounts may change based on
finalization which is expected to occur during the third quarter of fiscal 2007.
The assets acquired and liabilities assumed, based on the preliminary internal
valuation, are summarized below:
(IN THOUSANDS) Amount
- ---------------------------------------- -----------
Cash $ 8
Trade receivables, net 2,175
Inventories 17,950
Property and equipment 2,174
Goodwill 63,224
Intangible assets 9,600
Other assets 119
Accounts payable and accrued liabilities (57,957)
Obligations under capital leases (1,011)
-----------
Total consideration $ 36,282
===========
3. TRADE RECEIVABLES
Trade receivables consist of the following:
July 31,
2006 January 31,
(IN THOUSANDS) (unaudited) 2006
- ------------------------- ----------- -----------
Trade receivables $ 333,693 $ 348,620
Less allowances for:
Sales returns and other 196,382 198,156
Doubtful accounts 18,496 20,682
----------- -----------
Total allowances 214,879 218,838
----------- -----------
Trade receivables, net $ 118,814 $ 129,782
=========== ===========
Page 11 of 45
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
4. INVENTORIES
Inventories consist of the following:
July 31,
2006 January 31,
(IN THOUSANDS) (unaudited) 2006
- ------------------------------ ----------- -----------
Raw materials $ 3,272 $ 2,652
Work-in-process 3,342 3,458
Finished goods:
Pre-recorded music and video 123,352 131,601
Magazines and books 76,742 57,827
Fixtures 3,094 2,945
----------- -----------
Inventories $ 209,802 $ 198,483
=========== ===========
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.
5. GOODWILL AND INTANGIBLE ASSETS
A summary of the Company's intangible assets is as follows:
July 31,
2006 January 31,
(IN THOUSANDS) (unaudited) 2006
- ------------------------------ ----------- -----------
Amortized intangible assets:
Customer lists $ 125,780 $ 111,320
Non-compete agreements 2,250 2,250
Software 16,340 16,492
----------- -----------
Total intangibles 144,370 130,062
Accumulated amortization:
Customer lists (12,672) (8,133)
Non-compete agreements (830) (556)
Software (3,758) (2,385)
----------- -----------
Total accumulated amortization (17,260) (11,074)
----------- -----------
Intangibles, net $ 127,110 $ 118,988
=========== ===========
Amortization expense from intangible assets was $3.1 million and $1.9 million
for the three months ended July 31, 2006 and 2005, respectively and $6.2 million
and $3.5 million for the six months ended July 31, 2006 and 2005 respectively.
Amortization expense is expected to approximate $12.5 million for each of the
next five fiscal years.
Page 12 of 45
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
The changes in the carrying amount of goodwill for the six months ended July 31,
2006, are as follows:
CD and DVD Magazine In-Store
(IN THOUSANDS) Fulfillment Fulfillment Services Consolidated
- ---------------------------- ----------- ----------- ---------- ------------
Balance, January 31, 2006 $ 168,898 $ 78,601 $ 54,794 $ 302,293
Additions 35,097 90,936 738 126,771
Foreign currency translation
adjustments -- -- 55 55
----------- ----------- ---------- ------------
Balance, July 31, 2006 $ 203,995 $ 169,537 $ 55,587 $ 429,119
=========== =========== ========== ============
6. DEBT AND REVOLVING CREDIT FACILITY
Debt consists of:
July 31,
2006 January 31,
(IN THOUSANDS) (unaudited) 2006
- -------------------------------------------------------------- ----------- -----------
Revolving credit facility - Wells Fargo Foothill $ 116,906 $ 45,001
Note payable - Magazine import and export 4,871 6,227
Note payable - Former owner of Empire 517 717
Note payable - Former owner of Anderson Mid-Atlantic News, LLC 3,075 --
Note payable - Former owner of Anderson-SCN Services, LLC 7,650 --
Note payable - Arrangements with suppliers 11,006 11,815
Mortgage loan - Wachovia Bank 20,000 20,000
Equipment loans - Suntrust Leasing 5,269 3,216
Other 96 259
----------- -----------
Total debt 169,390 87,235
Less current maturities 18,335 6,508
----------- -----------
Debt, less current maturities $ 151,055 $ 80,727
=========== ===========
WELLS FARGO FOOTHILL CREDIT FACILITY
On February 28, 2005, the Company modified its existing credit facility with
Wells Fargo Foothill ("WFF") as a result of its acquisition of Alliance. The
primary changes from the original line of credit were to (1) increase the
maximum allowed advances under the line of credit from $45.0 million to $250.0
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 $10.0 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 $250.0 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.
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, 2006) based upon a ratio of the Company's EBITDA to interest expense
("Interest Coverage Ratio"). At July 31, 2006 the prime rate was 8.25%. 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
Page 13 of 45
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
Coverage Ratio. The Company had three LIBOR contracts outstanding at July 31,
2006 (expiring through October 2006) that bear interest at a weighted average
rate of approximately 7.23%. 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, 2006.
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 $42.0
million at July 31, 2006.
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, 2006 was $5.3 million.
SUPPLIER LOANS
Through the acquisition of Levy, the Company assumed four notes payable with
suppliers (the "Supplier Loans") totaling $14.0 million. The maturity dates of
the 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 $1.6
million and $1.7 million due to be repaid in fiscal year 2007 and 2008,
respectively. The total principal balance of the Supplier Loans as of July 31,
2006 was $11.0 million.
MORTGAGE LOAN
The Company obtained a 10 year, $20.0 million conventional mortgage loan through
Wachovia Bank (the "Wachovia Mortgage"). The Wachovia Mortgage is collateralized
by land and building located in Coral Springs, FL. The Wachovia Mortgage monthly
principal payments are approximately $0.08 million beginning in October 2006
plus interest at a rate of LIBOR plus a margin of 1.60%. At the end of the 10
year term, a balloon payment in the amount of $11.1 million is due and payable.
MAGAZINE IMPORT AND EXPORT NOTES
Concurrent with the magazine import and export acquisition in November 2004, the
Company issued an additional $7.7 million in notes payable. At July 31, 2006,
the balance on all magazine import and export notes was $4.9 million. These
notes bear interest at a rate of 2.37% and require quarterly payments through
February, 2008.
Page 14 of 45
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
NOTE TO FORMER OWNER OF MID-ATLANTIC
Concurrent with the acquisition of Mid-Atlantic, the Company issued a note
payable to its former owner for $4.1 million. The balance outstanding at July
31, 2006 was $3.1 million. The note bears interest at LIBOR minus 1.0% and
requires repayment of the outstanding balance in the third fiscal quarter of
2006.
NOTE TO FORMER OWNER OF SCN
Concurrent with the acquisition of SCN, the Company issued a note payable to its
former owner for $10.2 million. The balance outstanding at July 31, 2006 was
$7.7 million. The note bears interest at LIBOR minus 1.0% and requires repayment
of the outstanding balance in the third fiscal quarter of 2006.
The aggregate amount of debt maturing through January 31, 2011 is as follows:
(IN THOUSANDS) Amount
- ------------------- -----------
Fiscal year:
Remainder of 2007 $ 14,558
2008 7,850
2009 5,285
2010 119,687
2011 1,951
Thereafter 20,059
-----------
Total $ 169,390
===========
At July 31, 2006 and January 31, 2006, unamortized deferred financing fees were
approximately $1.9 million and $2.2 million, respectively.
7. COMMITMENTS AND CONTINGENCIES
The Company leases facilities, vehicles, an aircraft, computer and other
equipment under various capital and operating leases. Future minimum lease
payments under non-cancelable operating leases with terms of one year or more at
July 31, 2006 consist of the following:
(IN THOUSANDS) Amount
- ------------------- -----------
Fiscal year:
Remainder of 2007 $ 8,383
2008 13,217
2009 11,034
2010 9,125
2011 5,783
Thereafter 15,860
-----------
Total $ 63,402
===========
Page 15 of 45
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED
8. EARNINGS PER SHARE
A reconciliation of the denominators of the basic and diluted earnings per share
computations are as follows:
Three months ended July 31, Six months ended July 31,
--------------------------- -------------------------
2006 2005 2006 2005
----------- ------------ --------- ------------
Weighted average common shares outstanding - basic 51,811 51,140 51,760 46,800
Dilutive effect of stock options and warrants outstanding 1,480 1,820 1,463 1,951
----------- ------------ --------- ------------
Weighted average common shares outstanding - diluted 53,291 52,960 53,223 48,751
=========== ============ ========= ============
The following were not included in weighted average common
shares outstanding because they are antidilutive:
Stock options 221 349 330 287
Warrants 10 10 10 18
----------- ------------ --------- ------------
Total 231 359 340 305
=========== ============ ========= ============
9. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental information on interest and income taxes paid is as follows:
Six months ended July 31,
-----------------------------
(IN THOUSANDS) 2006 2005
- ---------------------------------------------- ----------- ------------
Interest $ 4,521 $ 2,325
Income taxes (net of receipts of $556 in 2006) $ 7,178 $ 2,596
----------- ------------
As discussed in Note 2, the Company acquired Mid-Atlantic on March 30, 2006 for
the total consideration of $17.7 million, including $13.6 million in cash and
$4.1 million in the form of a note payable.
As discussed in Note 2, the Company acquired SCN on March 30, 2006 for the total
consideration of $36.2 million, including $26.0 million in cash and $10.2
million in the form of a note payable.
10. STOCK-BASED COMPENSATION
On February 1, 2006, the Company adopted FAS No. 123(R), Share-Based Payment,
and chose to transition using the modified prospective method. Also on February
1, 2006, the Company granted approximately 0.1 million options to non-executive
members of its board of directors. The Company recognized stock compensation
expense of approximately $0.3 million associated with this grant. For the three
and six months ended July 31, 2006, the Company recorded $0.4 million in stock
compensation expense.
Prior to adoption of FAS No. 123(R), Share-Based Payment, the Company had
elected to apply Accounting Principles Board Opinion No. 25 to account for its
stock-based compensation plans, as permitted under FAS No. 123, Accounting for
Stock-Based Compensation (FAS No. 123). No stock compensation expense was
recognized during the three and six months ended July 31, 2005 as all options
granted in those periods had an exercise price equal or greater than the market
value of the underlying stock on the date of grant.
Page 16 of 45
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
The following is a reconciliation of the net income per weighted average share
had the Company adopted the fair-value provisions of FAS No. 123:
Three months Six months
ended July 31, ended July 31,
(IN THOUSANDS, EXCEPT PER SHARE DATA) 2005 2005
- ---------------------------------------------------- -------------- --------------
Net income - as reported $ 2,530 $ 4,201
Pro-forma stock compensation expense, net of tax (661) (1,331)
-------- --------
Pro-forma net income $ 1,869 $ 2,870
======== ========
Weighted average common shares outstanding - Basic 51,140 46,800
Weighted average common shares outstanding - Diluted 52,960 48,751
Earnings per share (as reported):
Basic $ 0.05 $ 0.09
Diluted $ 0.05 $ 0.09
Earnings per share (pro-forma):
Basic $ 0.04 $ 0.06
Diluted $ 0.04 $ 0.06
The fair value of each option grant is estimated on the grant date using the
Black-Scholes option pricing model with the following assumptions:
Six months ended July 31,
-------------------------
2006 2005
---------- -----------
Weighted average dividend yield 0.0 % 0.0 %
Weighted average expected volatility 41.4 % 50.0 %
Weighted average expected life 3.1 years 3.0 years
Weighted average risk-free interest rate 4.5 % 3.8 %
Weighted average fair value $ 3.79 $ 4.08
Under the Company's stock option plans, options to acquire shares of Common
Stock have been made available for grant to certain employees and non-employee
directors. Each option granted has an exercise price of not less than 100% of
the market value of the Common Stock on the date of grant. The contractual life
of each option is generally 10 years. The vesting of the grants varies according
to the individual options granted.
Range of Exercise Prices Weighted
Number of ------------------------ Average
Options Low High Exercise Price
--------- ----------- ----------- --------------
Options outstanding at January 31, 2006 3,927,190 $ 2.30 $ 18.31 $ 7.64
Options granted 71,712 11.39 11.39 11.39
Options forfeited or expired (3,700) 10.60 16.63 14.47
Options exercised (139,860) 2.30 10.78 8.40
--------- ----------- ----------- --------------
Options outstanding at July 31, 2006 3,855,342 $ 2.30 $ 18.31 $ 7.67
========= =========== =========== ==============
Page 17 of 45
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
The following table summarizes information about the stock options outstanding
at July 31, 2006:
Options Outstanding Options Exercisable
---------------------------------------------------- -----------------------------
Weighted Remaining Weighted
Number Average Contractual Number Average
Outstanding Exercise Price Life (Months) Exercisable Exercise Price
----------- -------------- ------------- ----------- --------------
Range of exercise prices:
$2.30 - $ 5.00 1,149,131 $ 4.54 11 - 78 1,149,131 $ 4.54
$5.01 - $ 7.50 691,250 5.31 18 - 76 691,250 5.31
$7.51 - $10.00 931,449 8.47 29 - 106 892,982 8.46
$10.01 - $15.00 976,212 11.29 32 - 114 976,212 11.29
$15.01 - $18.31 107,300 16.61 40 - 44 107,300 16.61
--------- ------- -------- --------- --------
Total 3,855,342 $ 7.67 11 - 114 3,816,875 $ 7.66
========= ======= ======== ========= ========
11. 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 unreleated third party. All assets and liabilities of the secondary
wholesale distribution operation were not assumed by the buyer. The Company
recognized a gain on the sale of this business of $1.4 million ($0.8 million 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.
12. SEGMENT FINANCIAL REPORTING
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.
Based on the comparability of the operations, Mid-Atlantic and SCN's results are
included in the Magazine Fulfillment group.
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.
Page 18 of 45
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
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.
The segment results are as follows:
CD and DVD Magazine In-Store
(IN THOUSANDS) Fulfillment Fulfillment Services Shared Services Consolidated
- ------------------------------------- ------------ ------------ ------------ --------------- ------------
THREE MONTHS ENDED JULY 31, 2006
Revenues $ 198,182 $ 223,240 $ 20,085 $ -- $ 441,507
Cost of revenues 160,487 172,175 13,005 -- 345,667
------------ ------------ ------------ --------------- ------------
Gross profit 37,695 51,065 7,080 -- 95,840
Selling, general and administrative
expense 19,603 26,648 2,381 5,795 54,427
Fulfillment freight 7,505 17,587 -- -- 25,092
Depreciation and amortization 3,616 1,728 144 524 6,012
Relocation expense -- 547 -- 168 715
------------ ------------ ------------ --------------- ------------
Operating income $ 6,971 $ 4,555 $ 4,555 $ (6,487) $ 9,594
============ ============ ============ =============== ============
AS OF JULY 31, 2006
Total assets $ 491,914 $ 353,603 $ 120,829 $ 37,278 $ 1,003,624
Goodwill, net $ 203,995 $ 169,537 $ 55,587 $ -- $ 429,119
Intangibles, net $ 83,985 $ 39,480 $ 3,645 $ -- $ 127,110
CD and DVD Magazine In-Store
(IN THOUSANDS) Fulfillment Fulfillment Services Shared Services Consolidated
- ------------------------------------- ------------ ------------ ------------ --------------- ------------
THREE MONTHS ENDED JULY 31, 2005
Revenues $ 208,640 $ 166,763 $ 18,387 $ -- $ 393,790
Cost of revenues 172,153 130,162 12,486 -- 314,801
------------ ------------ ------------ --------------- ------------
Gross profit 36,487 36,601 5,901 -- 78,989
Selling, general and administrative
expense 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 $ 6,841 $ 4,704 $ 3,593 $ (5,702) $ 9,436
============ ============ ============ =============== ============
AS OF JANUARY 31, 2006
Total assets $ 508,620 $ 208,523 $ 114,355 $ 52,976 $ 884,472
Goodwill, net $ 168,898 $ 78,601 $ 54,794 $ -- $ 302,293
Intangibles, net $ 87,742 $ 27,374 $ 3,872 $ -- $ 118,988
Page 19 of 45
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
CD and DVD Magazine In-Store
(IN THOUSANDS) Fulfillment Fulfillment Services Shared Services Consolidated
- -------------------------------------- ----------- ----------- -------- --------------- ------------
SIX MONTHS ENDED JULY 31, 2006
Revenues $ 438,872 $ 418,219 $ 39,016 $ -- $ 896,107
Cost of revenues 359,991 324,300 26,036 -- 710,327
----------- ----------- -------- --------------- ----------
Gross profit 78,881 93,919 12,980 -- 185,780
Selling, general and administrative
expense 41,408 50,754 4,617 11,968 108,747
Fulfillment freight 16,249 30,778 -- -- 47,027
Depreciation and amortization 7,074 3,379 290 1,074 11,817
Relocation expense -- 547 -- 168 715
Impairment of land and building
held for sale -- -- -- 529 529
----------- ----------- -------- --------------- ----------
Operating income $ 14,150 $ 8,461 $ 8,073 $ (13,739) $ 16,945
=========== =========== ======== =============== ==========
Capital Expenditures $ 3,026 $ 1,127 $ 157 $ 2,067 $ 6,377
----------- ----------- -------- --------------- ----------
Page 20 of 45
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONCLUDED)
(UNAUDITED)
CD and DVD Magazine In-Store
(IN THOUSANDS) Fulfillment Fulfillment Services Shared Services Consolidated
- ------------------------------------- ----------- ----------- -------- --------------- ------------
SIX MONTHS ENDED JULY 31, 2005
Revenues $ 357,102 $ 238,416 $ 32,693 $ -- $ 628,211
Cost of revenues 293,289 182,902 22,486 -- 498,677
----------- ----------- -------- --------------- ----------
Gross profit 63,813 55,514 10,207 -- 129,534
Selling, general and administrative
expense 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 $ 14,074 $ 8,499 $ 5,370 $ (14,170) $ 13,773
=========== =========== ======== =============== ==========
Capital Expenditures $ 3,788 $ 503 $ 237 $ 1,592 $ 6,120
----------- ----------- -------- --------------- ----------
Approximately $8.6 million and $8.5 million of the Company's total revenues in
the Magazine Fulfillment segment for the three months ended July 31, 2006 and
2005, respectively, and $17.5 million and $16.8 million of the Company's total
revenues in the Magazine Fulfillment segment for the six months ended July 31,
2006 and 2005, respectively, were derived from the export of U.S. publications
to overseas markets. At July 31, 2006 and January 31, 2006, identifiable assets
attributable to the export of U.S. publications were $21.2 million and $14.3
million.
Page 21 of 45
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Some of the information contained in this Quarterly Report on Form 10-Q
including, but not limited to, those contained in Item 2 of Part I "Management's
Discussion and Analysis of Financial Condition and Results of Operations," along
with statements in other reports filed with the Securities and Exchange
Commission (the "SEC"), external documents and oral presentations, 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 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 below under "Risk Factors" in our Annual Report for the fiscal year ended
January 31, 2006 on Form 10-K filed with the SEC on April 17, 2006:
- 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;
- changing market conditions and opportunities;
- our ability to realize operating efficiencies, cost savings and
other benefits from recent 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 below under "Risk Factors" in our Annual Report for
the fiscal year ended January 31, 2006 filed with the SEC on April 17, 2006
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 Item 2 of Part I "Management's Discussion
and Analysis of Financial Condition and Results of Operation." 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.
Page 22 of 45
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
We are a premier marketing, merchandising and fulfillment company of
entertainment products including DVDs, music CDs, magazines, books and related
items serving about 110,000 retail store locations throughout North America. Our
fully integrated businesses include:
- Distribution and fulfillment of entertainment products to major
retail chains throughout North America and direct-to-consumers via
the Internet;
- Import and export of periodicals sold in more than 100 markets
worldwide;
- Coordination of product selection and placement for impulse items
sold at checkout counters;
- Processing and collection of rebate claims as well as management of
sales data obtained at the point-of-purchase; and
- Design, manufacture and installation of wire fixtures and custom
wood displays in major retail chains.
Our clients include:
- Mainstream retailers, such as Wal-Mart Stores, Inc., The Kroger
Company, Target Corporation, Walgreen Company, Ahold USA, Inc.,
Sears Holdings Corporation., and Meijer, Inc.;
- Specialty retailers, such as Barnes & Noble, Inc., Borders 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.
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.
We have organized the company into three operating business units:
- Magazine Fulfillment - The magazine fulfillment segment sells and
distributes magazines to major retailers and wholesalers, imports
foreign titles for domestic retailers and wholesalers, exports
domestic titles to foreign wholesalers, provides return processing
services, serves as an outsource fulfillment agent and provides
customer-direct fulfillment.
- CD and DVD Fulfillment - The CD and DVD fulfillment segment sells
and distributes pre-recorded music, videos, video games and related
products to retailers, provides product and commerce solutions to
retailers and provides customer-direct fulfillment and vendor
managed inventory.
Page 23 of 45
- In-Store Services - The in-store services segment designs,
manufactures and invoices participants in front-end fixture
programs, provides claim filing services for rebates owed retailers
from publishers and their agents, designs, manufactures, ships,
installs and removes front-end wire and custom wood fixtures and
provides information and management services relating to retail
magazine sales to U.S. and Canadian retailers and magazine
publishers.
OVERVIEW
Significant events that occurred during the six months ended July 31, 2006 and
2005 include:
ACQUISITION OF ANDERSON MID-ATLANTIC NEWS, LLC
On March 30, 2006, we acquired all of the issued and outstanding membership
interests of Anderson Mid-Atlantic News, LLC ("Mid-Atlantic") from Anderson
News, LLC for a purchase price of approximately $4.0 million, subject to
adjustment based on the negative net worth as of the closing date of the
transaction. In addition, we provided approximately $9.6 million on the date of
acquisition to Mid-Atlantic to repay a portion of their outstanding intercompany
debt. The remaining outstanding intercompany debt of Mid-Atlantic was satisfied
by issuance of a promissory note totaling $4.1 million. The purchase price and
the intercompany debt repayment were funded by borrowings against our revolving
line of credit. Mid-Atlantic's results of operations have been included in our
Consolidated Financial Statements since the date of acquisition. The preliminary
allocation of purchase price is presented in Note 2 to our Consolidated
Financial Statements.
ACQUISITION OF ANDERSON-SCN SERVICES, LLC
On March 30, 2006, we acquired all of the issued and outstanding membership
interests of Anderson-SCN Services, LLC ("SCN") from Anderson News, LLC for a
purchase price of approximately $9.0 million, subject to adjustment based on the
negative net worth as of the closing date of the transaction. In addition, we
provided approximately $17.0 million on the date of acquisition to SCN to repay
a portion of their outstanding intercompany debt. The remaining outstanding
intercompany debt of SCN was satisfied by issuance of a promissory note totaling
$10.2 million. The purchase price and the intercompany debt repayment were
funded by borrowings against our revolving line of credit. SCN's results of
operations have been included in our Consolidated Financial Statements since the
date of acquisition. The preliminary allocation of purchase price is presented
in Note 2 to our Consolidated Financial Statements.
ACQUISITION OF CHAS. LEVY CIRCULATING COMPANY, LLC
On May 10, 2005, we entered into a Unit Purchase Agreement with Chas. Levy
Company, LLC. Under the terms of the agreement, we purchased all of the issued
and outstanding membership interests in Chas. Levy Circulating Co. LLC ("Levy")
from Seller 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.
In addition, approximately $19.3 million was also provided on the date of
acquisition to repay all outstanding intercompany debt of Levy. The purchase
price and the intercompany debt repayment were funded from the revolving line of
credit.
ACQUISITION OF ALLIANCE ENTERTAINMENT CORP.
On February 28, 2005, we completed the acquisition of Alliance Entertainment
Corp. ("Alliance"), 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").
Alliance historically operated two business segments: the Distribution and
Fulfillment Services Group ("DFSG") and the Digital Media Infrastructure
Services Group (the "DMISG"). Prior to the merger, on December 31, 2004,
Page 24 of 45
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 has provided 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 have been
strengthened. We also believe this transaction has positioned us as the
distribution channel of choice for film studios, record labels, publishers and
other producers of home entertainment content products. We have benefited 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 have
consolidated some distribution operations, reorganized others and leveraged our
best practices across all of our distribution operations. As a result, we
believe the merger has enhanced our financial strength, increased our visibility
in the investor community and strengthened our ability to pursue further
strategic acquisitions.
The total purchase price of approximately $315.5 million consisted of $304.7
million in Source Interlink common stock, representing approximately 26.9
million shares, $6.5 million related to the exchange of approximately 0.9
million shares of common stock on exercise of outstanding stock options,
warrants and other rights to acquire Alliance common stock and direct
transaction costs of $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 merger in November 2004.
The value of the stock options was determined using the Black-Scholes option
valuation model.
Page 25 of 45
RESULTS OF OPERATIONS
Please see our Annual Report on Form 10-K for the fiscal year ended January 31,
2006 and filed with the SEC on April 17, 2006 for more information on the types
of revenues and expenses included within the specific line-items in our
financial statements.
FOR THE THREE MONTHS ENDED JULY 31, 2006 AND 2005
The following table sets forth, for the periods presented, information relating
to our continuing operations, by segment for the three months ended July 31,
2006 and 2005:
Three months ended July 31,
----------------------------------------------
2006 2005
---------------------- --------------------
(IN THOUSANDS) Amount Margin % Amount Margin %
- ----------------------- ---------- --------- --------- --------
CD AND DVD FULFILLMENT
Revenues $ 198,182 $208,640
Cost of revenues 160,487 172,153
--------- --------
Gross profit 37,695 19.0% 36,487 17.5%
Operating expenses(a) 30,724 29,646
--------- --------
Operating income $ 6,971 3.5% $ 6,841 3.3%
========= ========= ======== ====
MAGAZINE FULFILLMENT
Revenues $ 223,240 $166,763
Cost of revenues 172,175 130,162
--------- --------
Gross profit 51,065 22.9% 36,601 21.9%
Operating expenses(a) 46,510 31,897
--------- --------
Operating income $ 4,555 2.0% $ 4,704 2.8%
========= ========= ======== ====
IN-STORE SERVICES
Revenues $ 20,085 $ 18,387
Cost of revenues 13,005 12,486
--------- --------
Gross profit 7,080 35.3% 5,901 32.1%
Operating expenses(a) 2,525 2,308
--------- --------
Operating income $ 4,555 22.7% $ 3,593 19.5%
========= ========= ======== ====
SHARED SERVICES
Revenues $ -- $ --
Cost of revenues -- --
--------- --------
Gross profit -- n/a -- n/a
Operating expenses(a) 6,487 5,702
--------- --------
Operating income (6,487) n/a (5,702) n/a
========= ========= ======== ====
TOTAL
Revenues $ 441,507 $393,790
Cost of revenues 345,667 314,801
--------- --------
Gross profit 95,840 21.7% 78,989 20.1%
Operating expenses(a) 86,246 69,553
--------- --------
Operating income $ 9,594 2.2% $ 9,436 2.4%
========= ========= ======== ====
(a) Operating expenses include selling, general and administrative expenses,
fulfillment freight, merger and acquisition charges, relocation expenses,
impairment of land and building held for sale, depreciation and
amortization of intangibles.
Page 26 of 45
REVENUES
Total revenues for the quarter ended July 31, 2006 increased $47.7 million, or
12.1%, from the same quarter of the prior year due primarily to the acquisition
of Mid-Atlantic and SCN in the first quarter of fiscal 2007.
CD and DVD Fulfillment
Our CD and DVD Fulfillment group's revenues were $198.2 million, a decrease of
$10.5 million, or 5.0%, from the same quarter of the prior year. The decrease is
due primarily a softer CD and DVD release schedule during the current quarter
versus same quarter of the previous year, partially offset by DVD sales to large
customers obtained in the second half of fiscal 2006.
Magazine Fulfillment
Our Magazine Fulfillment group's revenues were $223.2 million for the quarter
ended July 31, 2006. Compared to the comparable prior fiscal year period
revenues increased $56.5 million or 33.9%.
The group's revenues for the three months ended July 31, 2006 and 2005 are
comprised of the following components (in thousands):
Three months
ended July 31,
------------------------
(IN THOUSANDS) 2006 2005 Change
- ------------------- ---------- ---------- ----------
Domestic Mainstream $ 163,962 $ 101,789 $ 62,173
Domestic Specialty 50,725 56,456 (5,731)
Export 8,553 8,518 35
---------- ---------- ----------
Total $ 223,240 $ 166,763 $ 56,477
========== ========== ==========
Revenue consists of the gross amount of books and 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, transportation terminals, convenience stores
and drug stores. The mainstream distribution channel's revenues include book and
magazine distribution. The increase in sales is attributable to the acquisition
of Mid-Atlantic and SCN in the first quarter of fiscal 2007, and the inclusion
of a full quarter of Levy in fiscal 2007 versus the same quarter of the previous
year.
Domestic specialty revenues originate from magazine sales to "specialty"
retailers, which consist of bookstores, music outlets, office supply stores and
computer stores. The decreases in sales is due primarily to decreased sales to
our two major bookstore chains.
Export revenues originate from thee sale of domestic titles to foreign
wholesalers and brokers for distribution to foreign markets.
Sales efficiency expressed as a percentage of net distribution to gross
distribution was 33.6%, 39.6% and 36.5% for the mainstream, specialty and export
groups, respectively. The prior year comparable period efficiencies were 36.9%,
45.3% and 38.2%.
Page 27 of 45
In-Store Services
Our In-Store Services group's revenues were $20.1 million, an increase of $1.7
million, or 9.2%, from the same quarter of the prior year.
The group's revenues are comprised of the following components:
Three months
ended July 31,
------------------
(IN THOUSANDS) 2006 2005 Change
- ---------------------------- ------- ------- --------
Claim filing and information $ 4,091 $ 4,333 $ (242)
Front end wire and services 7,796 6,098 1,698
Wood 8,198 7,956 242
------- ------- -------
Total $20,085 $18,387 $ 1,698
======= ======= =======
Our claim filing revenues are recognized at the time the claim is paid. The $0.2
million decrease in claim filing and information is attributable to the timing
of the receipt of quarterly claim payments.
Our front end wire and services revenue increased $1.7 million due to increased
production for several large jobs for large chain retailers, compared to
relatively few large jobs during the same quarter of the prior year.
Our wood revenues increased $0.2 million due to increased store openings and
remodels performed by our major customers.
GROSS PROFIT
Gross profit for the period increased $16.9 million, or 21.3%, over the same
quarter of the prior year primarily due to the acquisition of Mid-Atlantic and
SCN in the current quarter.
Overall gross profit margins increased 1.6 percentage points in the current
quarter compared the same quarter of the prior year.
CD and DVD Fulfillment
Gross profit for our CD and DVD Fulfillment group was $37.7 million, an increase
of $1.2 million, or 3.3%, over the prior year. The increase relates primarily to
the inclusion of three months of results of operations from the group in the
current quarter compared to two months in the prior year. Gross profit margins
for the group increased from 17.5% in the prior year to 19.0% in the current
quarter, primarily due increased vendor managed inventory sales as well as
improved terms from suppliers during the current quarter.
Magazine Fulfillment
Our Magazine Fulfillment group's gross profit was $51.1 million for the quarter
ended July 31, 2006. Compared to the comparable prior fiscal year period gross
profit increased $14.5 million or 39.5%. Gross profit margin increased from
21.9% to 22.9%. The increase in gross profit margins is attributable to our
ability to leverage increased market share to obtain better pricing from certain
suppliers.
Page 28 of 45
In-Store Services
Our In-Store Services group's gross profit was $7.1 million in the current
quarter, an increase of $1.2 million, or 20.0%, compared to the same quarter of
the prior year. The group's gross profit margin increased from 32.1% to 35.3%.
The increase in gross profit is attributed primarily to the increase in wire
revenues discussed above and increased operational efficiency within our front
end wire and services group.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for the current quarter were $54.4
million, an increase of $7.5 million, or 15.9%, compared to the prior year.
Selling, general and administrative expenses as a percent of revenues increased
from 11.9% to 12.3%.
CD and DVD Fulfillment
Selling, general and administrative expenses for our CD and DVD Fulfillment
group remained relatively flat in the current quarter compared to the same
quarter of the previous fiscal year, decreasing $0.3 million or 1.4%. Selling,
general and administrative expenses as a percentage of the group's revenues
increased from 9.5% to 9.9%.
Magazine Fulfillment
The Magazine Fulfillment 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 $6.9 million, or 35.2%,
from $19.7 million to $26.6 million. The increase relates primarily to the
expansion of the group's mainstream distribution backroom operations and
in-store merchandising field force via the acquisition of SCN and Mid-Atlantic
during the first quarter of fiscal 2007 described above. Selling, general and
administrative expenses as a percentage of revenues were 11.9% and 11.8% for the
quarters ended July 31, 2006 and 2005, respectively.
In-Store Services
The In-Store Services group's selling, general and administrative expenses
remained relatively flat, increasing $0.2 million or 10.6%.
Shared Services
The selling, general and administrative expenses of the Shared Services group
increased $0.6 million, or 11.1% over the same quarter of the prior year. The
increase is primarily due to increased operating expenses to support our
significant growth. Shared services selling, general, and administrative
expenses remained flat as percentage of total revenues at 1.3%.
FULFILLMENT FREIGHT
Our fulfillment freight expenses were $25.1 million, an increase of $6.7
million, or 36.7%, compared to the prior year. The increase is primarily
attributable to significantly higher distribution due to the acquisition of SCN
and Mid-Atlantic during the first quarter of fiscal 2007, coupled with higher
fuel costs in the current quarter compared with the same quarter of the prior
year.
Page 29 of 45
DEPRECIATION AND AMORTIZATION
Depreciation and amortization was $6.0 million, an increase of $1.8 million, or
41.8%, compared to the prior year. The increase is primarily attributable to the
acquisition of Mid-Atlantic and SCN in the first quarter of fiscal 2007, and the
finalization of the valuation of Levy in the second half of fiscal 2006.
RELOCATION EXPENSE
The Company recorded expenses totaling $0.7 million in the quarter related to
the consolidation of the backroom operations and marketing functions of the
domestic mainstream distribution group from Lisle, IL to Bonita Springs, FL.
OPERATING INCOME
Operating income for the quarter ended July 31, 2006 increased $0.2 million, or
1.7%, compared to the prior year due to the factors described above.
Operating profit margins decreased from 2.4% to 2.2%, primarily due to increases
in various expenses as described above.
INTEREST EXPENSE
Interest expense includes the interest and fees on our significant debt
instruments and outstanding letters of credit. The increase of $1.1 million
relates to significantly higher borrowings during the current quarter due
primarily to the acquisition of Mid-Atlantic and SCN and increased interest
rates on debt.
OTHER INCOME (EXPENSE)
Other income (expense) consists of items outside the normal course of
operations. Due to its nature, comparability between periods is not generally
meaningful.
INCOME TAX EXPENSE
The effective tax rates were 40.0% and 47.7% for the current quarter and the
same quarter of the prior year, respectively. The decrease in the effective tax
rate is due to a revision of the treatment of certain timing differences. We
anticipate our effective tax rate to approximate 40% for the remainder of the
year.
DISCONTINUED OPERATIONS
In November 2004, we sold and disposed of our secondary wholesale distribution
operation for $1.4 million, in order to focus more fully on its domestic and
export distribution. In the second quarter of fiscal 2006, we wrote off certain
accounts receivable totaling $1.4 million, net of tax.
Page 30 of 45
FOR THE SIX MONTHS ENDED JULY 31, 2006 AND 2005
The following table sets forth, for the periods presented, information relating
to our continuing operations, by segment for the six months ended July 31, 2006
and 2005:
Six months ended July 31,
-------------------------------------------------
2006 2005
-------------------------------------------------
(IN THOUSANDS) Amount Margin% Amount Margin%
- ----------------------- ----------- ------- ---------- -------
CD AND DVD FULFILLMENT
Revenues $ 438,872 $ 357,102
Cost of revenues 359,991 293,289
----------- ---- ---------- ----
Gross profit 78,881 18.0% 63,813 17.9%
Operating expenses(a) 64,731 49,739
----------- ---- ---------- ----
Operating income $ 14,150 3.2% $ 14,074 3.9%
=========== ==== ========== ====
MAGAZINE FULFILLMENT
Revenues $ 418,219 $ 238,416
Cost of revenues 324,300 182,902
----------- ---- ---------- ----
Gross profit 93,919 22.5% 55,514 23.3%
Operating expenses(a) 85,458 47,015
----------- ---- ---------- ----
Operating income $ 8,461 2.0% $ 8,499 3.6%
=========== ==== ========== ====
IN-STORE SERVICES
Revenues $ 39,016 $ 32,693
Cost of revenues 26,036 22,486
----------- ---- ---------- ----
Gross profit 12,980 33.3% 10,207 31.2%
Operating expenses(a) 4,907 4,837
----------- ---- ---------- ----
Operating income $ 8,073 20.7% $ 5,370 16.4%
=========== ==== ========== ====
SHARED SERVICES
Revenues $ -- $ --
Cost of revenues -- --
----------- ---- ---------- ----
Gross profit -- n/a -- n/a
Operating expenses(a) 13,739 14,170
----------- ---- ---------- ----
Operating income (13,739) n/a (14,170) n/a
=========== ==== ========== ====
TOTAL
Revenues $ 896,107 $ 628,211
Cost of revenues 710,327 498,677
----------- ---- ---------- ----
Gross profit 185,780 20.7% 129,534 20.6%
Operating expenses(a) 168,835 115,761
----------- ---- ---------- ----
Operating income $ 16,945 1.9% $ 13,773 2.2%
=========== ==== ========== ====
(a) Operating expenses include selling, general and administrative expenses,
fulfillment freight, merger and acquisition charges, relocation expenses,
impairment of land and building held for sale, depreciation and
amortization of intangibles.
Page 31 of 45
REVENUES
Total revenues for the six months ended July 31, 2006 increased $267.9 million,
or 42.6%, from the same period of the prior year due primarily to:
- - The inclusion of six months of results from our CD and DVD Fulfillment
division in fiscal 2007 versus five months in fiscal 2006,
- - The acquisition of Levy in the second quarter of fiscal 2006, and
- - The acquisition of Mid-Atlantic and SCN in the first quarter of fiscal
2007.
CD and DVD Fulfillment
Our CD and DVD Fulfillment group's revenues were $438.9 million, an increase of
$81.8 million, or 22.9%, from the same quarter of the prior year. The increase
is primarily related to the inclusion of six month of results from our CD and
DVD Fulfillment group in fiscal 2007 versus five months in fiscal 2006.
Magazine Fulfillment
Our Magazine Fulfillment group's revenues were $418.2 million for the six months
ended July 31, 2006 compared to the comparable prior fiscal year period
revenues, an increase of $179.8 million or 75.4%.
The group's revenues for the six months ended July 31, 2006 and 2005 are
comprised of the following components (in thousands):
Six months ended July 31,
-------------------------
(IN THOUSANDS) 2006 2005 Change
- ------------------- ---------- ---------- ----------
Domestic Mainstream $ 290,406 $ 112,243 $ 178,163
Domestic Specialty 110,357 109,387 970
Export 17,456 16,786 670
---------- ---------- ----------
Total $ 418,219 $ 238,416 $ 179,803
========== ========== ==========
Revenue consists of the gross amount of books and 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, transportation terminals, convenience stores
and drug stores. The mainstream distribution channel's revenues include book and
magazine distribution. The increase in sales is attributable to two recent
acquisitions. In May 2005, the group significantly increased its presence in the
mainstream market with the acquisition of Chas. Levy Circulating Company, a
leading magazine wholesaler based in Chicago, IL, with distribution centers in
Chicago, IL, Lancaster, PA, Brainerd, MN, and City of Industry, CA. In March
2006, the group acquired additional mainstream distribution service areas in
Southern California and Washington DC/Baltimore markets, referred to above as
SCN and Mid-Atlantic, respectively.
Domestic specialty revenues originate from magazine sales to "specialty"
retailers, which consist of bookstores, music outlets, office supply stores and
computer stores. The increase in sales is primarily related to increased sales
to our two major bookstore chains.
Page 32 of 45
Export revenues originate from thee sale of domestic titles to foreign
wholesalers and brokers for distribution to foreign markets.
Sales efficiency expressed as a percentage of net distribution to gross
distribution was 33.5%, 41.7% and 37.1% for the mainstream, specialty and export
groups, respectively. The prior year comparable period efficiencies were 36.6%,
44.6% and 37.7%.
In-Store Services
Our In-Store Services group's revenues were $39.0 million, an increase of $6.3
million, or 19.3%, from the same quarter of the prior year.
The group's revenues are comprised of the following components:
Six months ended July 31,
-------------------------
(IN THOUSANDS) 2006 2005 Change
- ---------------------------- ---------- ---------- ----------
Claim filing and information $ 8,432 $ 7,877 $ 555
Front end wire and services 15,679 11,169 4,510
Wood 14,905 13,647 1,258
---------- ---------- ----------
Total $ 39,016 $ 32,693 $ 6,323
========== ========== ==========
Our claim filing revenues are recognized at the time the claim is paid. The $0.6
million increase in claim filing and information is attributable to the timing
of the receipt of quarterly claim payments.
Our front end wire and services revenue increased $4.5 million due to increased
production for several large jobs for large chain retailers, compared to
relatively few large jobs during the same quarter of the prior year.
Our wood revenues increased $1.3 million due to increased store openings and
remodels performed by our major customer.
GROSS PROFIT
Gross profit for the period increased $56.2 million, or 43.4%, over the same
period of the prior year primarily due to the inclusion of six months of results
from our CD and DVD Fulfillment group in fiscal 2007 compared to five months in
fiscal 2006, the acquisition of Levy in the second quarter of fiscal 2006 and
acquisition of Mid-Atlantic and SCN in the current quarter.
Overall gross profit margins increased 0.1 percentage points during the six
months ended July 31, 2006 compared the same period of the prior year.
CD and DVD Fulfillment
Gross profit for our CD and DVD Fulfillment group was $78.9 million, an increase
of $15.1 million, or 23.6%, over the prior year. The increase relates primarily
to the inclusion of six months of results of operations from the group in the
current quarter compared to five months in the prior year. Gross profit margins
for the group remained relatively flat, increasing from 17.9% in the prior year
to 18.0% in the six months ended July 31, 2006.
Page 33 of 45
Magazine Fulfillment
Our Magazine Fulfillment group's gross profit was $93.9 million for the six
months ended July 31, 2006. Compared to the comparable prior fiscal year period
gross profit increased $38.4 million or 69.2%. Gross profit margin decreased
from 23.3% to 22.5%.
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.
In-Store Services
Our In-Store Services group's gross profit was $13.0 million in the six months
ended July 31, 2006, an increase of $2.8 million, or 27.2%, compared to the same
period of the prior year. The group's gross profit margin increased from 31.2%
to 33.3%. The increase in gross profit is attributed primarily to the increase
in revenues discussed above and increased operational efficiency within our
front end wire and services group.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for the current quarter were $108.7
million, an increase of $32.1 million, or 41.9%, compared to the prior year.
This increase relates primarily to the acquisitions within the Magazine
Fulfillment and CD and DVD Fulfillment groups. Selling, general and
administrative expenses as a percent of revenues decreased from 12.2% to 12.1%.
CD and DVD Fulfillment
Selling, general and administrative expenses for our CD and DVD Fulfillment
group remained increased $8.2 million, or 24.6%, primarily due to the inclusion
of six months of results in fiscal 2007 compared to five months of results in
fiscal 2006. Selling, general and administrative expenses as a percentage of the
group's revenues increased from 9.3% to 9.4%.
Magazine Fulfillment
The Magazine Fulfillment 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. During the quarter the
group maintained two distribution centers in both the Mid-Atlantic and Southwest
United States due to its recent acquisitions. The group plans to consolidated
its distribution centers in these territories in the third quarter of the
current fiscal year.
Selling, general and administrative expenses increased $22.0 million, or 76.5%,
from $28.8 million to $50.8 million. The increase relates primarily to the
expansion of the group's mainstream distribution backroom operations and
in-store merchandising field force via the acquisitions described above.
Selling, general and administrative expenses as a percentage of revenues was
12.1% for both the first half of fiscal 2007and fiscal 2006.
In-Store Services
The In-Store Services group's selling, general and administrative expenses
remained relatively flat, increasing $0.3 million or 7.1%.
Page 34 of 45
Shared Services
The selling, general and administrative expenses of the Shared Services group
increased $1.6 million, or 15.9% over the same period of the prior year. The
increase is primarily due to increased operating expenses to support our
significant growth. As noted above, shared services selling, general, and
administrative expenses decreased as a percentage of total revenues from 1.6% to
1.3%.
FULFILLMENT FREIGHT
Our fulfillment freight expenses were $47.0 million, an increase of $18.3
million, or 63.9%, compared to the prior year. The increase is primarily
attributable to significantly higher distribution due to the inclusion of six
months of results from our CD and DVD Fulfillment group in fiscal 2007 compared
to five months in fiscal 2006, the acquisition of Levy in the second quarter of
fiscal 2006 and the acquisition of SCN and Mid-Atlantic during the first quarter
of fiscal 2007, coupled with significantly higher fuel costs in the current
period compared with the same period of the prior year.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization was $11.8 million, an increase of $4.5 million, or
60.9%, compared to the prior year. The increase is primarily attributable to the
inclusion of six months of results from our CD and DVD Fulfillment group in
fiscal 2007 compared to five months in fiscal 2006, the acquisition of Levy in
the second quarter of fiscal 2006 and the acquisition of SCN and Mid-Atlantic
during the first quarter of fiscal 2007, coupled with the finalization of the
valuation of Levy during the second half of fiscal 2006.
RELOCATION EXPENSE
The Company recorded expenses totaling $0.7 million in the second quarter of
fiscal 2007 related to the consolidation of the backroom operations and
marketing functions of the domestic mainstream distribution group from Lisle, IL
to Bonita Springs, FL.
IMPAIRMENT OF LAND AND BUILDING HELD FOR SALE
In May 2006, we entered into a contract to sell land and a building that we
owned during the second quarter of fiscal 2007. As such, we recorded an
impairment charge in the three months ended April 30, 2006 for the difference
between the estimated realizable value and the carrying amount of the land and
building.
OPERATING INCOME
Operating income for the six months ended July 31, 2006 increased $3.2 million,
or 23.0%, compared to the prior year due to the factors described above.
Operating profit margins decreased from 2.2% to 1.9%, primarily due to increases
in various expenses as described above.
INTEREST EXPENSE
Interest expense includes the interest and fees on our significant debt
instruments and outstanding letters of credit. The increase of $2.4 million
relates to significantly higher borrowings during the current quarter due
primarily to the acquisition of Mid-Atlantic and SCN and increased interest
rates on debt.
Page 35 of 45
OTHER INCOME (EXPENSE)
Other income (expense) consists of items outside the normal course of
operations. Due to its nature, comparability between periods is not generally
meaningful.
INCOME TAX EXPENSE
The effective tax rates were 38.7% and 49.2% for the current period and the same
period of the prior year, respectively. The decrease in the effective tax rate
is due to a revision of the treatment of certain timing differences. We
anticipate our effective tax rate to approximate 40% for the remainder of the
year.
DISCONTINUED OPERATIONS
In November 2004, we sold and disposed of our secondary wholesale distribution
operation for $1.4 million, in order to focus more fully on its domestic and
export distribution. In the second quarter of fiscal 2006, we wrote off certain
accounts receivable totaling $1.4 million, net of tax.
LIQUIDITY AND CAPITAL RESOURCES
Our primary sources of cash include receipts from our customers and borrowings
under our credit facilities and from time to time the proceeds from the sale of
common stock.
Our primary cash requirements for the Magazine Fulfillment and CD and DVD
Fulfillment groups consist of the cost of home entertainment products and the
cost of freight, labor and facility expense associated with our distribution
centers.
Our primary cash requirements for the In-Store Services group consist of the
cost of raw materials, labor, and factory overhead incurred in the production of
front-end wire and custom wood displays, the cost of labor incurred in providing
our claiming, design and information services and cash advances funding our
Advance Pay program. Our Advance Pay program allows retailers to accelerate
collections of their rebate claims through payments from us in exchange for the
transfer to us of the right to collect the claim. We then collect the claims
when paid by publishers for our own account.
Our primary cash requirements for the Shared Services group consist of salaries,
professional fees and insurance not allocated to the operation groups.
The following table presents a summary of our significant obligations and
commitments to make future payments under debt obligations and lease agreements
due by period as of July 31, 2006:
Payments due during the year ending January 31,
-------------------------------------------------------------
Remainder 2011 and
of 2007 2008 2009 2010 thereafter Total
---------- ----------- ----------- ---------- ---------- ----------
Debt obligations $ 14,558 $ 7,850 $ 5,285 $ 119,687 $ 22,010 $ 169,390
Interest payments(a) 6,218 8,073 4,580 1,225 343 20,439
Capital leases 421 864 808 261 -- 2,354
Operating leases 8,383 13,217 11,034 9,125 21,643 63,402
---------- ----------- ----------- ---------- ---------- ----------
Total contractual cash obligations $ 29,580 $ 30,004 $ 21,707 $ 130,298 $ 43,996 $ 255,808
========== =========== =========== ========== ========== ==========
(a) Interest is calculated using the prevailing weighted average rate on our
outstanding debt at July 31, 2006, using the required payment schedule.
Page 36 of 45
The following table presents a summary of our commercial commitments and the
notional amount expiration by period:
Notional amounts expiring during the year ending January 31,
-------------------------------------------------------------
2011 and
(IN THOUSANDS) 2007 2008 2009 2010 thereafter Total
- ---------------------------------- ---------- -------- ------- ------- ---------- ----------
Financial standby letters of credit $ 11,125 $ 864 $ -- $ -- $ -- $ 11,989
---------- -------- ------- ------- ---------- ----------
OPERATING CASH FLOW
Net cash used in operating activities was $40.8 million for the six months ended
July 31, 2006 and cash provided by operating activities was $15.4 million for
the six months ended July 31, 2005.
Six months ended July 31, 2006:
Operating cash flows for the six months ended July 31, 2006 were comprised of
net income of $7.4 million, plus non-cash charges including depreciation and
amortization of $12.7 million, provisions for losses on accounts receivable of
$2.2 million and a tax benefit on stock options exercised of $1.2 million.
Decreases in accounts receivable of $7.5 million and inventory of $13.7 million
also provided cash for the six month period ended July 31, 2006. These cash
providing activities were offset by a decrease in accounts payable and other
liabilities of $81.0 million and an increase in other current and non-current
assets of $3.2 million.
The decrease in accounts receivable was primarily due to a $39.2 million
decrease in accounts receivable within our CD and DVD Fulfillment group,
primarily related to the timing of receipts from major customers within the
first quarter of fiscal 2007 related to the holiday season. This decrease was
partially offset by a $26.1 million increase in accounts receivable in our
Magazine Fulfillment group. $15.2 million of the increase within the Magazine
Fulfillment group results from the timing of the acquisition of Mid-Atlantic and
SCN, approximately $7.9 million in new receivables as a result of bringing in
new customers and locations, coupled with the timing of receipts from major
customers. Additionally, increased production within our In-Store Services group
during the first quarter of fiscal 2007, versus fourth quarter fiscal 2006
resulted in $4.8 million in additional receivables.
The decrease in accounts payable was primarily due to a decrease in accounts
payable within our Magazine Fulfillment group of $43.1 million. $15.0 million of
this decrease results from the timing of the acquisition of Mid-Atlantic and
SCN, with the remainder attributable to the timing of vendor payments within the
first six months of fiscal 2007. Additionally, our CD and DVD Fulfillment group
had a decrease in accounts payable of $39.0 million associated with payments on
accounts payable originated under extended holiday season payment terms in the
fourth quarter of fiscal 2006.
The decrease in inventory was due to a decrease in inventories within our
Magazine Fulfillment group of $6.6 million and a decrease in inventory within
our CD and DVD Fulfillment group of $8.2 million. $4.7 million of the decrease
in our Magazine Fulfillment group resulted from the reduction in inventory
associated with aligning and streamlining the operations of Mid-Atlantic and SCN
following their acquisition. The decrease in inventories within our CD and DVD
Fulfillment group relates to the cyclical nature of the CD and DVD distribution
business.
Six months ended July 31, 2005:
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
Page 37 of 45
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.
INVESTING CASH FLOW
Net cash used in investing activities was $48.2 million and $43.0 million for
the six months ended July 31, 2006 and 2005, respectively.
For the six months ended July 31, 2006, cash used in investing activities
included capital expenditures of $6.5 million. Additionally, $39.7 million was
used to acquire Mid-Atlantic and SCN during the six months ended July 31, 2006.
For the six months ended July 31, 2005, cash used in investing activities
included 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.
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 requirement peak at
our fiscal quarter ends, the reported bank debt levels usually are the maximum
level outstanding during the quarter. 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.
Payments under our Advance Pay program generally occur just prior to our fiscal
quarter end. The related claims are not generally collected by us until 30-60
days after the advance is made. As a result, our funding requirements peak at
the time of the initial advances and decrease over this period as the cash is
collected on the related claims.
The front end 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 from all participants within 180
days. We are usually required to tender
Page 38 of 45
payment on the costs of these programs (raw material and labor) within a shorter
period. As a result, our funding requirements peak in the second and third
fiscal quarters when we manufacture the fixtures and decrease significantly in
the fourth and first fiscal quarters as the related receivable are collected and
significantly less manufacturing activity is occurring.
Net cash provided by financing activities was $68.2 million and $30.3 million
for the six months ended July 31, 2006 and 2005, respectively.
Financing activities in the first six months of fiscal year 2007 consisted
primarily of borrowings under credit facilities of $71.9 million, partially
offset by net payments on notes payable and capital leases of $5.1 million. The
significant borrowings on revolving credit facilities were primarily for the
purpose of acquiring the Mid-Atlantic and SCN service areas.
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.
DEBT
For a detailed description of the terms of our significant debt instruments,
please see Note 7 to our Consolidated Financial Statements.
Significant debt transactions during the six months ended July 31, 2006 are as
follows:
- In connection with the acquisition of Mid-Atlantic on March 30,
2006, we issued a promissory note to its former owner in the amount
of $4.1 million. The remaining balance is to be repaid in the third
quarter of fiscal 2007. It bears interest at the rate of LIBOR minus
1.0%. The remainder of the purchase price, $13.6 million, was funded
by borrowings on our revolving credit facility.
- In connection with the acquisition of SCN on March 30, 2006, we
issued a promissory note to its former owner in the amount of $10.2
million. The remaining balance is to be repaid in the third quarter
of fiscal 2007. It bears interest at the rate of LIBOR minus 1.0%.
The remainder of the purchase price, $26.0 million, was funded by
borrowings on our revolving credit facility.
OFF-BALANCE SHEET ARRANGEMENTS
We do not engage in transactions or arrangements with unconsolidated or other
special purpose entities.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our primary market risks include fluctuations in interest rates and exchange
rate variability.
Our debt primarily relates to credit facilities with Wells Fargo Foothill. See
Note 7 to our Consolidated Financial Statements.
The revolving credit facility with Wells Fargo Foothill had an outstanding
principal balance of $116.9 million at July 31, 2006. Interest on the
outstanding balance is charge based on a variable interest rate related to the
prime rate (8.25% at July 31, 2006) plus a margin specified in the credit
agreement based on an availability calculation (0.0% at July 31, 2006).
A 1.0% increase in the prevailing interest rate on our debt at July 31, 2006 is
estimated to cause an increase of $1.4 million in the interest expense for the
remainder of the year ending January 31, 2007.
We do not perform any interest rate hedging activities related to this facility.
We have exposure to foreign currency fluctuation through our exporting of
foreign magazines and the purchase of foreign magazines for domestic
distribution.
We derive a small amount of revenues from the export of foreign titles (or sales
to domestic brokers who facilitate the export). For the most part, our export
revenues are denominated in dollars, and the foreign wholesaler is subject to
foreign currency risks. We have the availability to control foreign currency
risk via increasing or decreasing the local cover price paid in the foreign
markets. There is a risk that a substantial increase in local cover price, due
to a decline in the local currency relative to the dollar, could decrease demand
for these magazines at retail and negatively impact our results of operations.
We also derive a small amount of revenue from domestic distribution of imported
titles. 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 control the foreign currency
risk. Foreign titles generally have significantly higher cover prices than
comparable domestic titles, are considered somewhat of a luxury item, are sold
only at select retail locations, and sales do not appear to be highly impacted
by cover price increases. However, a significant negative change in the relative
strength of the dollar to these foreign currencies could result in higher
domestic cover prices and result in lower sales of these titles at retail, which
would negatively impact our results of operations.
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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 Exchange Act) 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
Exchange Act, 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 SEC.
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.
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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 Exchange Act is recorded, processed, summarized
and reported within the time periods specified in SEC rules and forms and
include controls and procedures designed to ensure that information required to
be disclosed 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.
CHANGES IN INTERNAL CONTROLS OVER FINANCIAL REPORTING
Except as set forth in this paragraph, there were no changes in the Company's
internal controls over financial reporting (as defined in Rule 13a-15f of the
Exchange Act that occurred during the fiscal quarter ended July 31, 2006 that
have materially affected, or are reasonably likely to materially affect those
controls. During the first quarter of fiscal 2007, we transitioned certain
Magazine Fulfillment Accounts Receivable functions to an application acquired as
part of the Chas. Levy Circulating Co., LLC transaction. We implemented the
change to leverage our technological infrastructure and improve the efficiency
of transaction processing, not in response to an identified internal control
deficiency. This system migration will likely have a material effect on our
internal controls over financial reporting and will require testing for
effectiveness.
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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 of 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 1A. RISK FACTORS.
There were no material changes, additions or deletions from our risk factors as
presented in the section entitled "Risk Factors" in our Annual Report on Form
10-K for the year ended January 31, 2006 as filed with the SEC on April 17,
2006.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
Not Applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.
Not Applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not Applicable.
ITEM 5. OTHER INFORMATION.
Not Applicable.
ITEM 6. EXHIBITS.
See Exhibit Index.
Page 43 of 45
SIGNATURES
In accordance with the requirements of the Exchange Act, the Registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
SOURCE INTERLINK COMPANIES, INC.
September 11, 2006 By: /s/ Marc Fierman
---------------------
Marc Fierman
Chief Financial Officer
Page 44 of 45
EXHIBIT INDEX
EXHIBIT NO. 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 Certification of Principal Executive Officer and Principal Financial Officer.
Page 45 of 45