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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 October 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 fro 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 December 4, 2006 there were
51,914,012 shares of the Company's common stock outstanding.
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TABLE OF CONTENTS
PAGE
----
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS. 3
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS. 24
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. 43
ITEM 4. CONTROLS AND PROCEDURES. 44
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS. 46
ITEM 1A. RISK FACTORS. 46
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS. 46
ITEM 3. DEFAULTS UPON SENIOR SECURITIES. 46
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. 46
ITEM 5. OTHER INFORMATION. 46
ITEM 6. EXHIBITS. 46
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
INDEX OF FINANCIAL STATEMENTS
PAGE
----
Consolidated Balance Sheets as of October 31, 2006 (unaudited) and
January 31, 2006. 4
Consolidated Statements of Income for the three and nine months ended
October 31, 2006 and 2005 (unaudited). 6
Consolidated Statement of Stockholders' Equity for the nine months ended
October 31, 2006 (unaudited). 7
Consolidated Statements of Cash Flows for the nine months ended
October 31, 2006 and 2005 (unaudited). 8
Notes to Consolidated Financial Statements 9
Page 3 of 48
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
October 31, January 31,
2006 2006
----------- -----------
(unaudited)
ASSETS
Current assets
Cash $ 1,200 $ 23,239
Trade receivables, net 161,434 129,782
Purchased claims receivable 12,463 9,922
Inventories 273,074 198,483
Income tax receivable -- 2,180
Deferred tax asset 18,963 16,403
Other 6,377 6,058
---------- --------
Total current assets 473,511 386,067
---------- --------
Property, plants and equipment 99,290 89,971
Less accumulated depreciation and amortization (27,951) (23,255)
---------- --------
Net property, plants and equipment 71,339 66,716
---------- --------
Other assets
Goodwill, net 430,129 302,293
Intangibles, net 123,962 118,988
Other 10,108 10,408
---------- --------
Total other assets 564,199 431,689
---------- --------
Total assets $1,109,049 $884,472
========== ========
Page 4 of 48
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED BALANCE SHEETS (CONCLUDED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
October 31, January 31,
2006 2006
----------- -----------
(unaudited)
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable and accrued expenses (net
of allowance for returns of $184,822 and
$167,423 at October 31, 2006 and
January 31, 2006, respectively) $ 419,256 $321,074
Deferred revenue 2,433 3,226
Current portion of obligations under
capital leases 910 476
Current maturities of debt 7,591 6,508
Income taxes payable 209 --
---------- --------
Total current liabilities 430,399 331,284
Deferred tax liability 36,532 4,526
Obligations under capital leases 1,287 1,118
Debt, less current maturities 160,913 80,727
Other 6,107 7,224
---------- --------
Total liabilities 635,238 424,879
---------- --------
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; 51,914 and 51,704 shares
issued) 519 517
Additional paid-in-capital 469,350 467,543
---------- --------
Total contributed capital 469,869 468,060
Retained earnings (accumulated deficit) 1,367 (10,817)
Accumulated other comprehensive income:
Foreign currency translation 2,575 2,350
---------- --------
Total stockholders' equity 473,811 459,593
---------- --------
Total liabilities and stockholders' equity $1,109,049 $884,472
========== ========
See accompanying notes to Consolidated Financial Statements.
Page 5 of 48
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
Three months Nine months ended
ended October 31, October 31,
------------------- -----------------------
2006 2005 2006 2005
-------- -------- ---------- ----------
Revenues $475,775 $425,859 $1,371,882 $1,054,070
Cost of revenues (including depreciation of
$192, $311, $733, and $904, respectively) 370,852 339,765 1,081,179 838,442
-------- -------- ---------- ----------
Gross profit 104,923 86,094 290,703 215,628
Selling, general and administrative expense 57,683 48,355 166,430 125,001
Fulfillment freight 26,752 20,151 73,779 48,841
Depreciation and amortization 6,174 4,926 17,991 12,271
Merger and acquisition charges -- -- -- 3,094
Integration and relocation expense 2,582 -- 3,297 --
Disposal of land, buildings and equipment, net 152 -- 681 --
-------- -------- ---------- ----------
Operating income 11,580 12,662 28,525 26,421
-------- -------- ---------- ----------
Other income (expense):
Interest expense (including amortization of
deferred financing fees of $151, $184, $455,
and $486, respectively) (3,561) (1,964) (8,698) (4,642)
Interest income 41 68 153 158
Other (8) 84 62 233
-------- -------- ---------- ----------
Total other expense (3,528) (1,812) (8,483) (4,251)
-------- -------- ---------- ----------
Income from continuing operations, before
income taxes 8,052 10,850 20,042 22,170
Income tax expense 3,221 4,767 7,858 10,340
-------- -------- ---------- ----------
Income from continuing operations 4,831 6,083 12,184 11,830
Loss from discontinued operations, net of tax -- -- -- (1,446)
-------- -------- ---------- ----------
Net income $ 4,831 $ 6,083 $ 12,184 $ 10,384
======== ======== ========== ==========
Earnings per share - basic:
Continuing operations $ 0.09 $ 0.12 $ 0.24 $ 0.24
Discontinued operations -- -- -- (0.03)
-------- -------- ---------- ----------
Total $ 0.09 $ 0.12 $ 0.24 $ 0.21
======== ======== ========== ==========
Earnings per share - diluted:
Continuing operations $ 0.09 $ 0.11 $ 0.23 $ 0.24
Discontinued operations -- -- -- (0.03)
-------- -------- ---------- ----------
Total $ 0.09 $ 0.11 $ 0.23 $ 0.21
======== ======== ========== ==========
Weighted average common shares outstanding - basic 51,914 51,305 51,812 48,318
Weighted average common shares outstanding - diluted 53,120 53,012 53,190 50,188
-------- -------- ---------- ----------
See accompanying notes to Consolidated Financial Statements.
Page 6 of 48
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)
(UNAUDITED)
Retained Accumulated
Common Stock Additional Earnings Other Total
--------------- Paid-in (Accumulated Comprehensive Stockholders'
Shares Amount Capital Deficit) Income Equity
------ ------ ---------- ----------- ------------- -------------
Balance, January 31, 2006 51,704 $517 $467,543 $(10,817) $2,350 $459,593
Net income -- -- -- 12,184 -- 12,184
Foreign currency translation -- -- -- -- 225 225
------ ---- -------- -------- ------ --------
Comprehensive income -- -- -- 12,184 225 12,409
------ ---- -------- -------- ------ --------
Stock compensation expense -- -- 422 -- -- 422
Exercise of stock options and warrants 210 2 1,200 -- -- 1,202
Excess tax benefit from stock options
exercised -- -- 185 -- -- 185
------ ---- -------- -------- ------ --------
Balance, October 31, 2006 51,914 $519 $469,350 $ 1,367 $2,575 $473,811
====== ==== ======== ======== ====== ========
See accompanying notes to Consolidated Financial Statements.
Page 7 of 48
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
Nine months ended
October 31,
-------------------
2006 2005
-------- --------
OPERATING ACTIVITIES
Net income $ 12,184 $ 10,384
Adjustments to reconcile net income to net cash used in operating
activities:
Depreciation and amortization 19,179 13,661
Provision for losses on accounts receivable 3,143 2,792
Deferred revenue (554) 288
Stock compensation expense 422 --
Excess tax benefit from exercise of stock options 185 1,118
Impairment of land and building held for sale 529 --
Other (107) 217
Changes in assets and liabilities (excluding business acquisitions):
Increase in accounts receivable (43,521) (81,150)
Increase in inventories (49,810) (65,995)
Decrease in other current and non-current assets 785 7,944
Increase in accounts payable and other liabilities 22,379 97,296
-------- --------
Cash used in operating activities (35,186) (13,445)
-------- --------
INVESTMENT ACTIVITIES
Capital expenditures (12,566) (8,979)
Purchase of claims (83,335) (77,411)
Payments received on purchased claims 80,793 74,418
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 2,601 1,547
Other (1,330) --
-------- --------
Cash used in investing activities (53,570) (40,838)
-------- --------
FINANCING ACTIVITIES
Increase (decrease) in checks issued against revolving credit facilities -- (995)
Borrowings under credit facilities 83,867 56,646
Net Payments on notes payable and capital leases (18,353) (1,518)
Proceeds from the issuance of common stock 1,203 3,155
Deferred financing cost -- (1,076)
-------- --------
Cash provided by financing activities 66,717 56,212
-------- --------
(Decrease) increase in cash (22,039) 1,929
Cash, beginning of period 23,239 1,387
-------- --------
Cash, end of period $ 1,200 $ 3,316
======== ========
See accompanying notes to Consolidated Financial Statements.
Page 8 of 48
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 nine months ended October 31, 2006 and 2005 and our
financial position as of October 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 48
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 was repaid by the Company during the three months
ended October 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 $30.1 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 will to occur during the fourth 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 30,077
Intangible assets 4,700
Other assets 63
Accounts payable and accrued liabilities (25,134)
--------
Total consideration $ 17,752
========
Page 10 of 48
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
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 million. The promissory note was
repaid by the Company during the three months ended October 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 $61.1 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 will occur during the fourth 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 637
Inventories 17,950
Property and equipment 2,174
Goodwill 61,066
Intangible assets 9,600
Other assets 54
Accounts payable and accrued liabilities (54,196)
Obligations under capital leases (1,011)
--------
Total consideration $ 36,282
========
Page 11 of 48
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
3. TRADE RECEIVABLES
Trade receivables consist of the following:
October 31, January
(IN THOUSANDS) 2006 31, 2006
- -------------- ----------- --------
(unaudited)
Trade receivables $393,598 $348,620
Less allowances for:
Sales returns 215,343 198,156
Doubtful accounts 16,821 20,682
-------- --------
Total allowances 232,164 218,838
-------- --------
Trade receivables, net $161,434 $129,782
======== ========
4. INVENTORIES
Inventories consist of the following:
October 31, January
(IN THOUSANDS) 2006 31, 2006
- -------------- ----------- --------
(unaudited)
Raw materials $ 3,148 $ 2,652
Work-in-process 2,730 3,458
Finished goods:
Pre-recorded music and video 184,490 131,601
Magazines and books 80,155 57,827
Fixtures 2,551 2,945
-------- --------
Inventories $273,074 $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.
Page 12 of 48
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
5. INTANGIBLE ASSETS AND GOODWILL
A summary of the Company's intangible assets is as follows:
October 31, January
(IN THOUSANDS) 2006 31, 2006
- -------------- ----------- --------
(unaudited)
Amortized intangible assets:
Customer lists $125,782 $111,320
Non-compete agreements 2,250 2,250
Software 16,340 16,492
-------- --------
Total intangibles 144,372 130,062
Accumulated amortization:
Customer lists (15,000) (8,133)
Non-compete agreements (969) (556)
Software (4,441) (2,385)
-------- --------
Total accumulated amortization (20,410) (11,074)
-------- --------
Intangibles, net $123,962 $118,988
======== ========
Amortization expense from intangible assets was $3.2 million and $2.7 million
for the three months ended October 31, 2006 and 2005, respectively and $9.3
million and $6.5 million for the nine months ended October 31, 2006 and 2005
respectively. Amortization expense is expected to approximate $12.6 million for
each of the next five fiscal years.
The changes in the carrying amount of goodwill for the nine months ended October
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 91,908 738 127,743
Foreign currency translation
adjustments -- -- 93 93
-------- -------- ------- --------
Balance, October 31, 2006 $203,995 $170,510 $55,625 $430,129
======== ======== ======= ========
Page 13 of 48
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
6. DEBT AND REVOLVING CREDIT FACILITY
Debt consists of:
October 31, January
(IN THOUSANDS) 2006 31, 2006
- -------------- ----------- --------
(unaudited)
Revolving credit facility - Wells Fargo Foothill $128,868 $45,001
Note payable - Magazine import and export 4,188 6,227
Note payable - Former owner of Empire -- 717
Note payable - Arrangements with suppliers 10,397 11,815
Mortgage loan - Wachovia Bank 20,000 20,000
Equipment loans - Suntrust Leasing 4,769 3,216
Other 282 259
-------- -------
Total debt 168,504 87,235
Less current maturities 7,591 6,508
-------- -------
Debt, less current maturities $160,913 $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
October 31, 2006) based upon a ratio of the Company's EBITDA to interest expense
("Interest Coverage Ratio"). At October 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 Coverage Ratio. The Company had five LIBOR contracts
outstanding at October 31, 2006 with an aggregate principal amount of $115.0
million. The LIBOR contracts expire through December 2006 and bear interest at a
weighted average rate of approximately 7.37%. 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. On October 31, 2006, the Company amended its
existing credit facility. The primary changes to the existing facility were to
the definition of permitted investments and acquisitions, borrowing base, and
certain financial ratios. The Company was in compliance with these ratios at
October 31, 2006.
Page 14 of 48
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
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 $55.8
million at October 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 October 31, 2006 was $4.8 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 October
31, 2006 was $10.4 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.
The total principal balance of the Wachovia Mortgage as of October 31, 2006 was
$20.0 million.
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 October 31, 2006,
the balance on all magazine import and export notes was $4.2 million. These
notes bear interest at a rate of 2.37% and require quarterly payments through
February, 2008.
The aggregate amount of debt maturing through January 31, 2011 is as follows:
(IN THOUSANDS) Amount
- -------------- --------
Fiscal year:
Remainder of 2007 $ 1,712
2008 7,850
2009 5,285
2010 131,648
2011 1,951
Thereafter 20,058
--------
Total $168,504
========
Page 15 of 48
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
At October 31, 2006 and January 31, 2006, unamortized deferred financing fees
were approximately $1.8 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
October 31, 2006 consist of the following:
(IN THOUSANDS) Amount
- -------------- -------
Fiscal year:
Remainder of 2007 $ 5,384
2008 13,175
2009 10,926
2010 9,002
2011 5,820
Thereafter 15,947
-------
Total $60,254
=======
8. EARNINGS PER SHARE
A reconciliation of the denominators of the basic and diluted earnings per share
computations are as follows:
Three months ended Nine months ended
October 31, October 31,
------------------ -----------------
2006 2005 2006 2005
------ ------ ------ ------
Weighted average common shares outstanding - basic 51,914 51,305 51,812 48,318
Dilutive effect of stock options and warrants outstanding 1,206 1,707 1,378 1,870
------ ------ ------ ------
Weighted average common shares outstanding - diluted 53,120 53,012 53,190 50,188
====== ====== ====== ======
The following were not included in weighted average common
shares outstanding because they are antidilutive:
Stock options 903 349 521 308
Warrants 10 10 10 10
------ ------ ------ ------
Total 913 359 531 318
====== ====== ====== ======
Page 16 of 48
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
9. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental information on interest and income taxes paid is as follows:
Nine months ended
October 31,
-----------------
(IN THOUSANDS) 2006 2005
- -------------- ------ ------
Interest $7,754 $3,916
Income taxes (net of receipts of $556 in 2007) $9,850 $2,890
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 of October 31, 2006, this note
was repaid.
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. As of October 31, 2006, this note was
repaid.
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 nine months ended October 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 nine months ended October 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 17 of 48
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 Nine months
ended ended
October 31, October 31,
(IN THOUSANDS, EXCEPT PER SHARE DATA) 2005 2005
- ------------------------------------- ------------ -----------
Net income - as reported $ 6,083 $10,384
Pro-forma stock compensation expense, net of tax (69) (1,400)
------- -------
Pro-forma net income $ 6,014 $ 8,984
======= =======
Weighted average common shares outstanding - Basic 51,305 48,318
Weighted average common shares outstanding -
Diluted 53,012 50,188
Earnings per share (as reported):
Basic $ 0.12 $ 0.21
Diluted $ 0.11 $ 0.21
Earnings per share (pro-forma):
Basic $ 0.12 $ 0.19
Diluted $ 0.11 $ 0.18
The fair value of each option grant is estimated on the grant date using the
Black-Scholes option pricing model with the following assumptions:
Nine months ended October 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 Weighted
Prices Average
Number of ----------------- Exercise
Options Low High Price
--------- ------ ------ --------
Options outstanding at January 31, 2006 3,927,190 $ 2.30 $18.31 $ 7.64
Options granted 41,175 11.15 11.15 11.15
Options forfeited or expired (153,700) 10.60 16.63 11.08
Options exercised (142,185) 2.30 10.78 8.40
--------- ------ ------ ------
Options outstanding at October 31, 2006 3,672,480 $ 2.30 $18.31 $ 7.50
========= ====== ====== ======
Page 18 of 48
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
The following table summarizes information about the stock options outstanding
at October 31, 2006:
Options Outstanding Options Exercisable
-------------------------------------- ----------------------
Weighted Weighted
Average Remaining Average
Number Exercise Contractual Number Exercise
Outstanding Price Life (Months) Exercisable Price
----------- -------- ------------- ----------- --------
Range of exercise prices:
$2.30 - $5.00 1,149,631 $ 4.54 8 - 75 1,149,631 $ 4.54
$5.01 - $7.50 691,250 5.31 15 - 73 691,250 5.31
$7.51 - $10.00 928,624 8.47 25 - 103 928,624 8.47
$10.01 - $15.00 795,675 11.33 29 - 111 794,875 11.33
$15.01 - $18.31 107,300 16.61 37 - 41 107,300 16.61
--------- ------ -------- --------- ------
Total 3,672,480 $ 7.50 8 - 111 3,671,680 $ 7.50
========= ====== ======== ========= ======
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 19 of 48
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 to 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 Shared
(IN THOUSANDS) Fulfillment Fulfillment Services Services Consolidated
- -------------- ----------- ----------- -------- -------- ------------
THREE MONTHS ENDED OCTOBER 31, 2006
Revenues $233,250 $222,237 $ 20,288 $ -- $ 475,775
Cost of revenues 189,079 168,495 13,278 -- 370,852
-------- -------- -------- -------- ----------
Gross profit 44,171 53,742 7,010 -- 104,923
Selling, general and administrative expense 21,854 28,286 2,008 5,535 57,683
Fulfillment freight 8,641 18,111 -- -- 26,752
Depreciation and amortization 3,682 1,855 139 498 6,174
Integration and relocation expense -- 2,451 -- 131 2,582
Disposal of land, buildings and equipment, net 287 (49) (86) -- 152
-------- -------- -------- -------- ----------
Operating income (loss) $ 9,707 $ 3,088 $ 4,949 $ (6,164) $ 11,580
======== ======== ======== ======== ==========
AS OF OCTOBER 31, 2006
Total assets $624,513 $259,212 $124,879 $100,445 $1,109,048
Goodwill, net $203,995 $170,510 $ 55,625 $ -- $ 430,129
Intangibles, net $ 82,107 $ 38,323 $ 3,532 $ -- $ 123,962
CD and DVD Magazine In-Store Shared
(IN THOUSANDS) Fulfillment Fulfillment Services Services Consolidated
- -------------- ----------- ----------- -------- -------- ------------
THREE MONTHS ENDED OCTOBER 31, 2005
Revenues $226,401 $176,735 $ 22,723 $ -- $425,859
Cost of revenues 186,003 137,739 16,023 -- 339,765
-------- -------- -------- ------- --------
Gross profit 40,398 38,996 6,700 -- 86,094
Selling, general and administrative
expense 20,736 20,306 2,021 5,292 48,355
Fulfillment freight 7,787 12,364 -- -- 20,151
Depreciation and amortization 3,020 1,238 149 519 4,926
-------- -------- -------- ------- --------
Operating income (loss) $ 8,855 $ 5,088 $ 4,530 $(5,811) $ 12,662
======== ======== ======== ======= ========
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 20 of 48
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
CD and DVD Magazine In-Store Shared
(IN THOUSANDS) Fulfillment Fulfillment Services Services Consolidated
- -------------- ----------- ----------- -------- -------- ------------
NINE MONTHS ENDED OCTOBER 31, 2006
Revenues $672,122 $640,456 $59,304 $ -- $1,371,882
Cost of revenues 549,070 492,795 39,314 -- 1,081,179
-------- -------- ------- -------- ----------
Gross profit 123,052 147,661 19,990 -- 290,703
Selling, general and administrative expense 63,262 79,040 6,625 17,503 166,430
Fulfillment freight 24,890 48,889 -- -- 73,779
Depreciation and amortization 10,756 5,234 429 1,572 17,991
Integration and relocation expense -- 2,998 -- 299 3,297
Disposal of land, buildings and equipment, net 287 (49) 86 529 529
-------- -------- ------- -------- ----------
Operating income (loss) $ 23,857 $ 11,549 $13,022 $(19,903) $ 28,525
======== ======== ======= ======== ==========
Capital Expenditures $ 5,426 $ 2,957 $ 280 $ 3,902 $ 12,566
CD and DVD Magazine In-Store Shared
(IN THOUSANDS) Fulfillment Fulfillment Services Services Consolidated
- -------------- ----------- ----------- -------- -------- ------------
NINE MONTHS ENDED OCTOBER 31, 2005
Revenues $583,503 $415,151 $55,416 $ -- $1,054,070
Cost of revenues 479,292 320,641 38,509 -- 838,442
-------- -------- ------- -------- ----------
Gross profit 104,211 94,510 16,907 -- 215,628
Selling, general and administrative
expense 53,968 49,081 6,329 15,623 125,001
Fulfillment freight 19,391 29,450 -- -- 48,841
Depreciation and amortization 7,923 2,406 450 1,492 12,271
Merger and acquisition charges -- -- 227 2,867 3,094
-------- -------- ------- -------- ----------
Operating income (loss) $ 22,929 $ 13,573 $ 9,901 $(19,982) $ 26,421
======== ======== ======= ======== ==========
Capital Expenditures $ 5,605 $ 822 $ 502 $ 2,050 $ 8,979
Approximately $8.7 million and $7.4 million of the Company's total revenues in
the Magazine Fulfillment segment for the three months ended October 31, 2006 and
2005, respectively, and $26.2 million and $24.2 million of the Company's total
revenues in the Magazine Fulfillment segment for the nine months ended October
31, 2006 and 2005, respectively, were derived from the export of U.S.
publications to overseas markets. At October 31, 2006 and January 31, 2006,
identifiable assets attributable to the export of U.S. publications were $28.4
million and $14.3 million.
Page 21 of 48
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONCLUDED)
(UNAUDITED)
13. SUBSEQUENT EVENTS
Effective November 10, 2006, S. Leslie Flegel ("Flegel"), the Company's then
Chairman of the Board of Directors and Chief Executive Officer, resigned from
the Company and its Board of Directors pursuant to a Separation, Consulting and
General Release Agreement dated November 12, 2006 (the "Separation Agreement").
The Company's Board of Directors has since named Michael R. Duckworth, a
director of the Company, Chairman of the Board of Directors. The Company's then
President and Chief Operating Officer, James R. Gillis, and the Company's then
Executive Vice President and President and Chief Operating Officer of the
Company's Alliance Entertainment Corporation subsidiary, Alan Tuchman, have
since been named interim co-Chief Executive Officers.
Pursuant to the terms of the Separation Agreement, the Company is required to
pay to Flegel (1) $0.9 million no later than March 15, 2007, as his annual bonus
for fiscal year 2007, (2) $4.6 million on May 21, 2007, as a lump sum severance
payment, (3) $1.0 million per year for consulting services, in monthly
installments, for three years, beginning on November 10, 2006, with payment for
the first six months of this term due on May 21, 2007, and (4) up to $4.0
million upon the completion of certain business ventures or agreements. In
addition, the Company is required to provide Flegel with an office facility, an
assistant and healthcare insurance and is required to reimburse Flegel for
reasonable and necessary expenses incurred by Flegel in the interest of the
business of the Company.
In the event that any of the above payments to Flegel are subject to the tax
imposed by Section 4999 of the Internal Revenue Code, the Company is required to
pay to Flegel an additional amount such that Flegel is maintained in the same
economic position as he would have been if the payments had not been subject to
the tax.
The Company also amended certain stock option grants to Flegel to extend the
expiration date to three and one half months from the date of termination. As a
result, the Company will recognize compensation expense of approximately $1.3
million in the fourth quarter of fiscal 2007.
After preliminary review, the Company expects to recognize approximately $9.5
million in expense related to this event during the fourth quarter of fiscal
2007.
On November 30, 2006, the Company announced that it will streamline its Board of
Directors, reducing the number of Board members to nine, from 11 members
previously. In addition to S. Leslie Flegel's previous resignation, A. Clinton
Allen announced his immediate resignation from the Company's Board of Directors
on November 30, 2006.
Page 22 of 48
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 23 of 48
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 24 of 48
- 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 nine months ended October 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").
Page 25 of 48
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 26 of 48
RESULTS OF OPERATIONS
Please see our Annual Report on Form 10-K for the fiscal year ended January 31,
2006 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.
Page 27 of 48
FOR THE THREE MONTHS ENDED OCTOBER 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 October 31,
2006 and 2005:
Three months ended October 31,
-----------------------------------------
2006 2005
------------------- -------------------
(IN THOUSANDS) Amount Margin % Amount Margin %
- -------------- -------- -------- -------- --------
CD AND DVD FULFILLMENT
Revenues $233,250 $226,401
Cost of revenues 189,079 186,003
-------- --------
Gross profit 44,171 18.9% 40,398 17.8%
Operating expenses(a) 34,464 31,543
-------- --------
Operating income $ 9,707 4.2% $ 8,855 3.9%
======== ========
MAGAZINE FULFILLMENT
Revenues $222,237 $176,735
Cost of revenues 168,495 137,739
-------- --------
Gross profit 53,742 24.2% 38,996 22.1%
Operating expenses(a) 50,654 33,908
-------- --------
Operating income $ 3,088 1.4% $ 5,088 2.9%
======== ========
IN-STORE SERVICES
Revenues $ 20,288 $ 22,723
Cost of revenues 13,278 16,023
-------- --------
Gross profit 7,010 34.6% 6,700 29.5%
Operating expenses(a) 2,061 2,170
-------- --------
Operating income $ 4,949 24.4% $ 4,530 19.9%
======== ========
SHARED SERVICES
Revenues $ -- $ --
Cost of revenues -- --
-------- --------
Gross profit -- n/a -- n/a
Operating expenses(a) 6,164 5,811
-------- --------
Operating loss (6,164) n/a (5,811) n/a
======== ========
TOTAL
Revenues $475,775 $425,859
Cost of revenues 370,852 339,765
-------- --------
Gross profit 104,923 22.1% 86,094 20.2%
Operating expenses(a) 93,343 73,432
-------- --------
Operating income $ 11,580 2.4% $ 12,662 3.0%
======== ========
(a) Operating expenses include selling, general and administrative expenses,
fulfillment freight, merger and acquisition charges, integration and
relocation expenses, impairment of land and building held for sale, gain on
sale of building, loss on sale of equipment, net, depreciation and
amortization of intangibles.
Page 28 of 48
REVENUES
Total revenues for the quarter ended October 31, 2006 increased $49.9 million,
or 11.7%, 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 $233.3 million, an increase of
$6.8 million, or 3.0%, from the same quarter of the prior year. The increase is
due primarily to DVD sales to large customers obtained in the second half of
fiscal 2006 and higher consumer direct fulfillment sales, partially offset by a
softer CD and DVD release schedule during the current quarter versus same
quarter of the previous year. The third quarter of the prior year was also
negatively impacted by hurricane Wilma, which disrupted the last week of
shipments in the quarter.
Magazine Fulfillment
Our Magazine Fulfillment group's revenues were $222.2 million for the quarter
ended October 31, 2006. Compared to the comparable prior fiscal year period,
revenues increased $45.5 million or 25.7%.
The group's revenues for the three months ended October 31, 2006 and 2005 are
comprised of the following components (in thousands):
Three months
ended October 31,
-------------------
(IN THOUSANDS) 2006 2005 Change
- -------------- -------- -------- -------
Domestic Mainstream $158,355 $114,207 $44,148
Domestic Specialty 55,758 55,085 673
Export 8,124 7,443 681
-------- -------- -------
Total $222,237 $176,735 $45,502
======== ======== =======
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.
Domestic specialty revenues originate from magazine sales to "specialty"
retailers, which consist of bookstores, music outlets, office supply stores and
computer stores. Domestic specialty revenues remained relatively flat compared
to the same quarter of the prior year.
Export revenues originate from the 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 33.2%, 42.4% and 34.6% for the mainstream, specialty and export
groups, respectively. The prior year comparable period efficiencies were 36.7%,
44.0% and 32.0%.
Page 29 of 48
In-Store Services
Our In-Store Services group's revenues were $20.3 million, a decrease of $2.4
million, or 10.7%, from the same quarter of the prior year.
The group's revenues are comprised of the following components:
Three months
ended October 31,
-----------------
(IN THOUSANDS) 2006 2005 Change
- -------------- ------- ------- -------
Claim filing and information $ 3,264 $ 4,079 $ (815)
Front end wire and services 9,139 7,983 1,156
Wood 7,885 10,661 (2,776)
------- ------- -------
Total $20,288 $22,723 $(2,435)
======= ======= =======
Our claim filing revenues are recognized at the time the claim is paid. The $0.8
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 $1.2 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 decreased $2.8 million due to comparatively fewer remodels and
new store openings performed by our major customers.
GROSS PROFIT
Gross profit for the period increased $18.8 million, or 21.9%, over the same
quarter of the prior year primarily due to the acquisition of Mid-Atlantic and
SCN in the first quarter of fiscal 2007.
Overall gross profit margins increased 1.9 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 $44.2 million, an increase
of $3.8 million, or 9.3%, over the prior year. The increase is primarily due to
improved gross profit margins of the same quarter of the prior year. Gross
profit margins for the group increased from 17.8% in the prior year to 18.9% in
the current quarter, primarily due to 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 $53.7 million for the quarter
ended October 31, 2006. Compared to the comparable prior fiscal year period
gross profit increased $14.7 million or 37.8%. Gross profit margin increased
from 22.1% to 24.2%. The increase in gross profit margins is attributable to our
ability to negotiate better pricing from certain suppliers as a result of our
enhanced market position.
Page 30 of 48
In-Store Services
Our In-Store Services group's gross profit was $7.0 million in the current
quarter, an increase of $0.3 million, or 4.6%, compared to the same quarter of
the prior year. The group's gross profit margin increased from 29.5% to 34.6%.
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 $57.7
million, an increase of $9.3 million, or 19.3%, compared to the prior year.
Selling, general and administrative expenses as a percent of revenues increased
from 11.4% to 12.1%.
CD and DVD Fulfillment
Selling, general and administrative expenses for our CD and DVD Fulfillment
group increased $1.1 million or 5.4% from the same quarter of the prior year.
The increase is attributable in part to increased field service costs associated
with certain new accounts. Selling, general and administrative expenses as a
percentage of the group's revenues increased from 9.2% 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 field
service and the backroom operations.
Selling, general and administrative expenses increased $8.0 million, or 39.3%,
from $20.3 million to $28.3 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 12.7% and 11.5% for the
quarters ended October 31, 2006 and 2005, respectively.
In-Store Services
The In-Store Services group's selling, general and administrative expenses
remained relatively flat at $2.0 million.
Shared Services
The selling, general and administrative expenses of the Shared Services group
increased $0.2 million, or 4.6% 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 1.2%.
FULFILLMENT FREIGHT
Our fulfillment freight expenses were $26.8 million, an increase of $6.6
million, or 32.8%, 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
surcharges on air and ground third party shipments in the current quarter
compared with the same quarter of the prior year.
Page 31 of 48
DEPRECIATION AND AMORTIZATION
Depreciation and amortization was $6.2 million, an increase of $1.2 million, or
25.3%, 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.
INTEGRATION AND RELOCATION EXPENSE
The Company recorded expenses totaling $2.6 million for the three months ended
October 31, 2006 related to the consolidation of the backroom operations and
marketing functions of the domestic mainstream distribution group from Lisle, IL
to Bonita Springs, FL and the consolidation of one of its existing southern
California distribution centers into a facility acquired in connection with the
acquisition of SCN in the first quarter of fiscal 2007.
DISPOSAL OF LAND, BUILDINGS AND EQUIPMENT
During the third quarter of fiscal 2007, we sold a building and equipment in the
normal course of business. As such, we recorded gains or losses related to the
difference between the sales price and the carrying amount of these assets.
OPERATING INCOME
Operating income for the quarter ended October 31, 2006 decreased $1.1 million,
or 8.5%, compared to the prior year due to the factors described above.
Operating profit margins decreased from 3.0% to 2.4%, 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 $1.6 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 43.9% 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.
Page 32 of 48
FOR THE NINE MONTHS ENDED OCTOBER 31, 2006 AND 2005
The following table sets forth, for the periods presented, information relating
to our continuing operations, by segment for the nine months ended October 31,
2006 and 2005:
Nine months ended October 31,
---------------------------------------------
2006 2005
--------------------- ---------------------
(IN THOUSANDS) Amount Margin % Amount Margin %
- -------------- ---------- -------- ---------- --------
CD AND DVD FULFILLMENT
Revenues $ 672,122 $ 583,503
Cost of revenues 549,070 479,292
---------- ----------
Gross profit 123,052 18.3% 104,211 17.9%
Operating expenses(a) 99,195 81,282
---------- ----------
Operating income $ 23,857 3.5% $ 22,929 3.9%
========== ==========
MAGAZINE FULFILLMENT
Revenues $ 640,456 $ 415,151
Cost of revenues 492,795 320,641
---------- ----------
Gross profit 147,661 23.1% 94,510 22.8%
Operating expenses(a) 136,112 80,937
---------- ----------
Operating income $ 11,549 1.8% $ 13,573 3.3%
========== ==========
IN-STORE SERVICES
Revenues $ 59,304 $ 55,416
Cost of revenues 39,314 38,509
---------- ----------
Gross profit 19,990 33.7% 16,907 30.5%
Operating expenses(a) 6,968 7,006
---------- ----------
Operating income $ 13,022 22.0% $ 9,901 17.9%
========== ==========
SHARED SERVICES
Revenues $ -- $ --
Cost of revenues -- --
---------- ----------
Gross profit -- n/a -- n/a
Operating expenses(a) 19,903 19,982
---------- ----------
Operating loss (19,903) n/a (19,982) n/a
========== ==========
TOTAL
Revenues $1,371,882 $1,054,070
Cost of revenues 1,081,179 838,442
---------- ----------
Gross profit 290,703 21.2% 215,628 20.5%
Operating expenses(a) 262,178 189,207
---------- ----------
Operating income $ 28,525 2.1% $ 26,421 2.5%
========== ==========
(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, gain on sale of building,
loss on sale of equipment, net, depreciation and amortization of
intangibles.
Page 33 of 48
REVENUES
Total revenues for the nine months ended October 31, 2006 increased $317.8
million, or 30.2%, from the same period of the prior year due primarily to:
- The inclusion of nine months of results from our CD and DVD
Fulfillment division in fiscal 2007 versus eight 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 $672.1 million, an increase of
$88.6 million, or 15.2%, from the same period of the prior year. The increase is
primarily related to the inclusion of nine month of results from our CD and DVD
Fulfillment group in fiscal 2007 versus eight months in fiscal 2006.
Magazine Fulfillment
Our Magazine Fulfillment group's revenues were $640.5 million for the nine
months ended October 31, 2006, an increase of $225.3 million or 54.3% compared
to the comparable prior fiscal year period revenues.
The group's revenues for the nine months ended October 31, 2006 and 2005 are
comprised of the following components (in thousands):
Nine months
ended October 31,
-------------------
(IN THOUSANDS) 2006 2005 Change
- -------------- -------- -------- --------
Domestic Mainstream $448,762 $223,592 $225,170
Domestic Specialty 167,050 167,330 (280)
Export 24,644 24,229 415
-------- -------- --------
Total $640,456 $415,151 $225,305
======== ======== ========
Revenues consist 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 consist 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 three recent
acquisitions. In May 2005, the group significantly increased its presence in the
mainstream market with the acquisition of Chas. Levy Circulating Co., a leading
magazine wholesaler based in Chicago, IL, with distribution centers in Chicago,
IL, Lancaster, PA, and Brainerd, MN. 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.
Page 34 of 48
Domestic specialty revenues originate from magazine sales to "specialty"
retailers, which consist of bookstores, music outlets, office supply stores and
computer stores. The decrease in sales is primarily related 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 33.4%, 42.0% and 35.4% for the mainstream, specialty and export
groups, respectively. The prior year comparable period efficiencies were 36.7%,
44.4% and 35.7%.
In-Store Services
Our In-Store Services group's revenues were $59.3 million, an increase of $3.9
million, or 7.0%, from the same period of the prior year.
The group's revenues are comprised of the following components:
Nine months ended
October 31,
-----------------
(IN THOUSANDS) 2006 2005 Change
- -------------- ------- ------- -------
Claim filing and information $11,696 $11,956 $ (260)
Front end wire and services 24,818 19,151 5,667
Wood 22,790 24,309 (1,519)
------- ------- -------
Total $59,304 $55,416 $ 3,888
======= ======= =======
Our claim filing revenues are recognized at the time the claim is paid. The $0.3
million decrease in claim filing and information is attributable primarily to
the timing of the receipt of quarterly claim payments.
Our front end wire and services revenue increased $5.7 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 decreased $1.5 million due to comparatively fewer remodels and
store openings performed by our major customers.
GROSS PROFIT
Gross profit for the period increased $75.1 million, or 34.8%, over the same
period of the prior year primarily due to the inclusion of nine months of
results from our CD and DVD Fulfillment group in fiscal 2007 compared to eight
months in fiscal 2006, the acquisition of Levy in the second quarter of fiscal
2006 and acquisitions of Mid-Atlantic and SCN in the first quarter of fiscal
2007.
Overall gross profit margins increased 0.7 percentage points during the nine
months ended October 31, 2006 compared the same period of the prior year.
Page 35 of 48
CD and DVD Fulfillment
Gross profit for our CD and DVD Fulfillment group was $123.1 million, an
increase of $18.8 million, or 18.1%, over the prior year. The increase relates
primarily to the inclusion of nine months of results of operations from the
group in the current period compared to eight months in the prior year. Gross
profit margins for the group increased from 17.9% in the prior year to 18.3% in
the nine months ended October 31, 2006.
Magazine Fulfillment
Our Magazine Fulfillment group's gross profit was $147.7 million for the nine
months ended October 31, 2006. Compared to the comparable prior fiscal year
period gross profit increased $53.2 million or 56.2%, primarily due to the
acquisition of Levy in the second quarter of fiscal 2006 and acquisitions of
Mid-Atlantic and SCN in the first quarter of fiscal 2007. Gross profit margin
increased from 22.8% to 23.1%. The increase in gross profit margins is
attributable to our ability negotiate better pricing from certain suppliers as a
result of our enhanced market position.
In-Store Services
Our In-Store Services group's gross profit was $20.0 million in the nine months
ended October 31, 2006, an increase of $3.1 million, or 18.2%, compared to the
same period of the prior year. The group's gross profit margin increased from
30.5% to 33.7%. 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 period were $166.4
million, an increase of $41.4 million, or 33.1%, compared to the same period of
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 increased from 11.9% to 12.1%.
CD and DVD Fulfillment
Selling, general and administrative expenses for our CD and DVD Fulfillment
group increased $9.3 million, or 17.2%, primarily due to the inclusion of nine
months of results in fiscal 2007 compared to eight months of results in fiscal
2006. Selling, general and administrative expenses as a percentage of the
group's revenues increased from 9.2% 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. For the majority of the
nine months ended October 31, 2006, the group maintained two distribution
centers in the Southwest United States due to its recent acquisitions. The group
consolidated its distribution centers in this territory in the third quarter of
the current fiscal year.
Selling, general and administrative expenses increased $29.9 million, or 61.0%,
from $49.1 million to $79.0 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 the group's
revenues increased from 11.8% to 12.3%.
Page 36 of 48
In-Store Services
The In-Store Services group's selling, general and administrative expenses
remained relatively flat, increasing $0.3 million or 4.7%.
Shared Services
The selling, general and administrative expenses of the Shared Services group
increased $1.9 million, or 12.0% 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 1.5% to
1.3%.
FULFILLMENT FREIGHT
Our fulfillment freight expenses were $73.8 million, an increase of $24.9
million, or 51.1%, compared to the prior year. The increase is primarily
attributable to significantly higher distribution due to the inclusion of nine
months of results from our CD and DVD Fulfillment group in fiscal 2007 compared
to eight months in fiscal 2006, the acquisition of Levy in the second quarter of
fiscal 2006 and the acquisitions of SCN and Mid-Atlantic during the first
quarter of fiscal 2007, coupled with higher surcharges on air and ground third
party shipments in the current quarter compared with the same period of the
prior year.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization was $18.0 million, an increase of $5.7 million, or
46.6%, compared to the prior year. The increase is primarily attributable to the
inclusion of nine months of results from our CD and DVD Fulfillment group in
fiscal 2007 compared to eight 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.
INTEGRATION AND RELOCATION EXPENSE
The Company recorded expenses totaling $3.0 million for the nine months ended
October 31, 2006 related to the consolidation of the backroom operations and
marketing functions of the domestic mainstream distribution group from Lisle, IL
to Bonita Springs, FL and the consolidation of one of its existing southern
California distribution centers into a facility acquired in connection with the
acquisition of SCN in the first quarter of fiscal 2007.
DISPOSAL OF LAND, BUILDINGS AND EQUIPMENT
During the first nine months of fiscal 2007, we sold a building and equipment in
the normal course of business. As such, we recorded gains or losses related to
the difference between the sales price and the carrying amount of these assets.
Page 37 of 48
OPERATING INCOME
Operating income for the nine months ended October 31, 2006 increased $2.1
million, or 8.0%, compared to the prior year due to the factors described above.
Operating profit margins decreased from 2.5% to 2.1%, 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 $4.1 million
relates to significantly higher borrowings during the current period 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 39.2% and 46.6% 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.
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 38 of 48
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 October 31, 2006:
Payments due during the year ending January 31,
-----------------------------------------------------
Remainder 2011 and
of 2007 2008 2009 2010 thereafter Total
--------- ------- ------- -------- ---------- --------
Debt obligations $ 1,712 $ 7,850 $ 5,285 $131,648 $22,009 $168,504
Interest payments(a) 3,305 12,880 12,415 10,373 5,236 44,209
Capital leases 266 863 808 261 -- 2,198
Operating leases 5,384 13,175 10,926 9,002 21,767 60,254
------- ------- ------- -------- ------- --------
Total contractual cash obligations $10,667 $34,768 $29,434 $151,284 $49,012 $275,165
======= ======= ======= ======== ======= ========
(a) Interest is calculated using the prevailing weighted average rate on our
outstanding debt at October 31, 2006, using the required payment schedule.
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 $1,675 $5,164 $-- $-- $-- $6,839
Page 39 of 48
OPERATING CASH FLOW
Net cash used in operating activities was $35.2 and $13.4 million for the nine
months ended October 31, 2006 and the nine months ended October 31, 2005,
respectively.
Nine months ended October 31, 2006:
Operating cash flows for the nine months ended October 31, 2006 were comprised
primarily of net income of $12.2 million, plus non-cash charges including
depreciation and amortization of $19.2 million and provisions for losses on
accounts receivable of $3.1 million. An increase in accounts payable of $22.4
million also provided cash for this period. These cash providing activities were
offset by increases in accounts receivable of $43.5 million and inventory of
$49.8 million.
The increase in accounts payable of $22.4 million was primarily attributable to
an increase in accounts payable within our CD and DVD Fulfillment group of $56.9
million associated with the buildup of holiday season inventory under extended
payment terms. This increase was partially offset by a decrease in accounts
payable within our Magazine Fulfillment group of $34.8 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 nine months of fiscal 2007.
The increase in accounts receivable of $43.5 million results primarily from an
increase in accounts receivable of $28.5 million within our CD and DVD
Fulfillment group associated with sales to customers under extended payment
terms in preparation for the holiday season and from an increase in accounts
receivable within our Magazine Fulfillment group of $7.1 million. The increase
within our Magazine Fulfillment group results primarily from the timing of the
acquisition of Mid-Atlantic and SCN and new receivables as a result of adding
new customers. Also, increased production with our In-Store Services group
created an increase in accounts receivable of $8.4 million.
The increase in inventory of $49.8 million was due primarily to an increase in
inventory within our CD and DVD Fulfillment group of $52.9 million associated
with the buildup of holiday season inventory under extended payment terms. This
increase was partially offset by a decrease in inventories within our Magazine
Fulfillment group of $3.1 million resulting from the reduction in inventory
associated with aligning and streamlining the operations of Mid-Atlantic and SCN
following their acquisition.
Nine months ended October 31, 2005:
Operating cash flows for the nine months ended October 31, 2005 were comprised
of net income of $10.4 million, plus non-cash charges including depreciation and
amortization of $13.2 million, amortization of deferred loan costs of $0.5
million, provisions for losses on accounts receivable of $2.8 million, a tax
benefit received on stock options exercised of $1.1 million and an increase of
$0.3 million in deferred revenue. An increase in accounts payable and other
liabilities of $97.3 million and a decrease in other assets of $7.9 million also
provided cash for the nine month period ended October 31, 2005. These cash
providing activities were offset by an increase in inventories of $66.0 million
and an increase in accounts receivable of $81.2 million.
The increase in accounts receivable for the nine months ended October 31, 2005
of $81.2 million was primarily due to a increase of $23.4 million from the
Magazine Fulfillment group primarily as a result of certain negotiated
collection terms and a $52.7 million increase in the CD and DVD Fulfillment
group due to extending customer payment terms and timing of customer payments.
Historically, customer payment terms have been extended for the holiday season.
Page 40 of 48
The increase in inventories of $66.0 million for the nine months ended October
31, 2005 was primarily due to the acquisition of the CD and DVD Fulfillment
group on February 28, 2005, as approximately $57.6 million of the increase was
attributable to their purchases subsequent to the date of acquisition. This
buildup in inventories for the CD and DVD Fulfillment group in the third quarter
is primarily to support the holiday shopping season of the fourth quarter.
The increase in accounts payable and other current and non-current liabilities
in the nine months ended October 31, 2005 of $97.3 million relates to the timing
of vendor payments in the nine months ended October 31, 2005 as compared to the
quarter ended January 31, 2005. In addition, favorable terms have been
negotiated for purchases of inventory, which increases significantly in third
quarter due to the holiday season.
INVESTING CASH FLOW
Net cash used in investing activities was $53.6 million and $40.8 million for
the nine months ended October 31, 2006 and 2005, respectively.
For the nine months ended October 31, 2006, cash used in investing activities
was comprised of $12.6 million in capital expenditures and $2.5 million in net
advanced pay expenditures, partially offset by proceeds from the sale of fixed
assets of $2.6 million. Additionally, $39.7 million was used to acquire
Mid-Atlantic and SCN during the nine months ended October 31, 2006.
For the nine months ended October 31, 2005, cash used in investing activities
was comprised of capital expenditures of $9.0 million, which was partially
offset by $1.5 million in proceeds from the sale of equipment. Our advance pay
program used $3.0 million in the nine months ended October 31, 2005. 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 $25.7 million in the
purchase of Levy, net of cash acquired. 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 requirements 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 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 receivables are collected and significantly less manufacturing
activity is occurring.
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Net cash provided by financing activities was $66.7 million and $56.2 million
for the nine months ended October 31, 2006 and 2005, respectively.
For the nine months ended October 31, 2006, cash provided by financing
activities was comprised primarily of borrowings under our revolving credit
facility of $83.9. This was partially offset by net payments on debt and capital
leases of $18.4 million.
For the nine months ended October 31, 2005, cash provided by financing
activities consisted of borrowings under the credit facilities of $56.6 million
and $20.0 million obtained from the mortgage loan. These funds were offset by
repayments of $21.5 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 $8.5
million relating to the repayment of the mortgage loan obtained in the Alliance
transaction, and a decrease of $1.0 million in checks issued and outstanding at
October 31, 2005. Finally, the exercise of employee stock options in the quarter
generated approximately $3.2 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 nine months ended October 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 balance was repaid in the third quarter of fiscal 2007.
- 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 was repaid in the third quarter of fiscal 2007.
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 $128.9 million at October 31, 2006. Interest on the
outstanding balance is charge based on a variable interest rate related to the
prime rate (8.25% at October 31, 2006) plus a margin specified in the credit
agreement based on an availability calculation (0.0% at October 31, 2006).
A 1.0% increase in the prevailing interest rate on our debt at October 31, 2006
is estimated to cause an increase of $0.3 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 domestic 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
principal 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 principal 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 principal 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 principal 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 Principal 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.
Page 45 of 48
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 46 of 48
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.
December 11, 2006 By: /s/ Marc Fierman
------------------------------------
Marc Fierman
Chief Financial Officer
Page 47 of 48
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.
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