FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: March 31, 2001 Commission file No. 0-15338
-------------- -------
PHOTOWORKS, INC.
----------------
(Exact name of registrant as specified in its charter.)
Washington 91-0964899
- ---------------------------------------- --------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1260 16th Avenue West, Seattle, WA 98119
- ---------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (206) 281-1390
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 the
filing requirements for the past 90 days.
Yes X No
--- ---
As of April 30, 2001, there were issued and outstanding 16,612,105 shares
of common stock, par value $.01 per share.
Index to Exhibits at Page 17
Page 1 of 17
PHOTOWORKS, INC.
INDEX
-----
Page No.
--------
PART I -- FINANCIAL INFORMATION
Item 1 - Financial Statements 3-9
Consolidated Balance Sheets as of March 31, 2001
and September 30, 2000 3-4
Consolidated Statements of Operations for the second quarter
and six months ended March 31, 2001 and March 25, 2000 5
Consolidated Statements of Cash Flows for the six months
ended March 31, 2001 and March 25, 2000 6
Notes to Consolidated Financial Statements 7-9
Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations 10-13
PART II -- OTHER INFORMATION
Item 1 - Legal Proceedings 14
Item 4 - Submission of Matters to a Vote of Security Holders 14
Item 6 - Exhibits and Reports on Form 8-K 15
SIGNATURES 16
INDEX TO EXHIBITS 17
EXHIBITS 18
Page 2 of 17
PART I -- FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
PHOTOWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
(UNAUDITED) (NOTE)
March 31, September 30,
ASSETS 2001 2000
==========================================================================================
CURRENT ASSETS
Cash and cash equivalents $ 531 $ 1,629
Securities available-for-sale - 1,022
Accounts receivable, net of allowance for doubtful accounts 1,075 1,300
Inventories 2,881 5,562
Prepaid promotional expenditures 806 1,412
Prepaid income taxes - 970
Prepaid expenses and other 218 377
------- -------
TOTAL CURRENT ASSETS 5,511 12,272
FURNITURE, FIXTURES, AND EQUIPMENT,
at cost, less accumulated depreciation 9,638 12,390
TOTAL ASSETS $15,149 $24,662
======= =======
Note: The September 30, 2000 consolidated balance sheet has been derived from
audited consolidated financial statements.
See notes to consolidated financial statements.
Page 3 of 17
PHOTOWORKS, INC.
CONSOLIDATED BALANCE SHEETS (continued)
(in thousands, except per share and share data)
(UNAUDITED) (NOTE)
March 31, September 30,
LIABILITIES AND SHAREHOLDERS' EQUITY 2001 2000
============================================================================================
CURRENT LIABILITIES
Accounts payable $ 4,616 $ 5,478
Accrued compensation 1,451 1,854
Accrued expenses 1,811 1,732
Current portion of note payable 3,653 821
Current portion of capital lease obligation 233 250
-------- -------
TOTAL CURRENT LIABILITIES 11,764 10,135
Note payable, net of current portion - 1,231
Capital lease obligation, net of current portion 187 292
-------- -------
TOTAL LONG TERM LIABILITIES 187 1,523
-------- -------
TOTAL LIABILITIES 11,951 11,658
SHAREHOLDERS' EQUITY
Preferred Stock, $.01 par value, authorized 2,000,000 shares,
issued and outstanding 15,000 shares - -
Common Stock, $.01 par value, authorized 101,250,000
shares, issued and outstanding 16,612,105 166 165
Additional paid-in capital 15,752 15,629
Retained earnings (12,720) (2,790)
-------- -------
TOTAL SHAREHOLDERS' EQUITY 3,198 13,004
-------- -------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 15,149 $24,662
======== =======
Note: The September 30, 2000 consolidated balance sheet has been derived from
audited consolidated financial statements.
See notes to consolidated financial statements.
Page 4 of 17
PHOTOWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(in thousands, except per share and share data)
Second Quarter Ended Six Months Ended
-------------------------- --------------------------
March 31, March 25, March 31, March 25,
2001 2000 2001 2000
=========== =========== =========== ===========
Net revenues $ 12,690 $ 18,796 $ 27,675 $ 39,287
Cost of goods and services 10,947 13,506 23,245 26,958
----------- ----------- ----------- -----------
Gross Profit 1,743 5,290 4,430 12,329
Operating expenses:
Marketing expenses 5,199 7,516 7,765 13,823
Research and development 1,350 618 2,525 1,083
General and administrative 2,088 1,796 3,937 3,031
----------- ----------- ----------- -----------
Total operating expenses 8,637 9,930 14,227 17,937
----------- ----------- ----------- -----------
Loss from Operations (6,894) (4,640) (9,797) (5,608)
Other income (expense):
Interest income 17 364 44 635
Interest expense (118) (12) (287) (23)
Non-operating income (expense), net 99 (7) 111 (21)
----------- ----------- ----------- -----------
Total other income (expense) (2) 345 (132) 591
----------- ----------- ----------- -----------
Loss before income taxes (6,896) (4,295) (9,929) (5,017)
Provision for income taxes - (496) - (246)
----------- ----------- ----------- -----------
Net loss (6,896) (4,791) (9,929) (5,263)
Preferred stock accretion - (1,035) - (1,035)
----------- ----------- ----------- -----------
Loss attributable to common shareholders $ (6,896) $ (5,826) $ (9,929) $ (6,298)
=========== =========== =========== ===========
Net loss per share $(.42) $(.29) $(.60) $(.32)
=========== =========== =========== ===========
Net loss per common share $(.42) $(.36) $(.60) $(.39)
=========== =========== =========== ===========
Weighted average shares outstanding 16,522,000 16,368,000 16,514,000 16,347,000
=========== =========== =========== ===========
See notes to consolidated financial statements.
Page 5 of 17
PHOTOWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(in thousands)
Six Months Ended
----------------------
March 31, March 25,
2001 2000
========= =========
OPERATING ACTIVITIES:
- ---------------------
Net loss $(9,929) $ (5,263)
Charges to income not affecting cash:
Depreciation and amortization 3,738 2,129
Loss on disposal of assets 236 -
Deferred income taxes - 1,334
Net change in receivables, inventories, payables and other 2,099 2,574
Prepaid promotional expenditures (444) (1,988)
------- --------
NET CASH USED IN OPERATING ACTIVITIES (4,300) (1,214)
INVESTING ACTIVITIES:
- ---------------------
Purchase of furniture, fixtures, and equipment (172) (2,784)
Purchases of securities available-for-sale - (13,740)
Sales of securities available-for-sale 1,022 2,928
------- --------
NET CASH FROM (USED IN) INVESTING ACTIVITIES 850 (13,596)
FINANCING ACTIVITIES:
- ---------------------
Proceeds from issuance of Preferred Stock - 14,974
Proceeds from issuance of Common Stock 124 283
Drawing on bridge loan 2,350 -
Payment on capital lease obligation (122) (45)
------- --------
NET CASH FROM FINANCING ACTIVITIES 2,352 15,212
------- --------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (1,098) 402
Cash and cash equivalents at beginning of period 1,629 15,001
------- --------
CASH AND CASH EQUIVALENTS
AT END OF PERIOD $ 531 $ 15,403
======= ========
See notes to consolidated financial statements.
Page 6 of 17
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE A -- BASIS OF PRESENTATION
PhotoWorks, Inc. ("PhotoWorks" or the "Company") is a leading photo
services company dedicated to providing its customers with innovative ways to
enjoy and use their photos. The Company, formerly Seattle FilmWorks, Inc.,
changed its corporate name to PhotoWorks, Inc. on February 1, 2000. The
PhotoWorks service provides film and image processing and online image storage
and management services to both traditional and digital camera users, providing
customers with the easiest way to store and organize photos online, share them
with friends and family, and order reprints, photo albums, and photo related
products. The Company also offers an array of complementary products and
services, primarily under the brand names PhotoWorks(R) and Seattle
FilmWorks(R). To a lesser extent, the Company provides photo-related products on
a wholesale basis.
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Rule 10-01 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring adjustments) considered necessary for fair presentation of
interim results have been included. The Company follows a policy of recording
its interim periods and year-end on a 5 week, 4 week and 4 week basis for
comparability of results and to be consistent with its internal weekly
reporting. Fiscal year 2001 will include 52 weeks compared to fiscal 2000 that
included 53 reporting weeks, with the additional week reported in the fourth
quarter of fiscal 2000. Operating results for the second quarter ended March 31,
2001 are not necessarily indicative of the results that may be expected for the
fiscal year ending September 29, 2001. For further information, refer to the
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" under Item 2 below and under Item 7 of Part II of the Company's
Annual Report on Form 10-K for the year ended September 30, 2000 and the
Company's consolidated financial statements and footnotes thereto also included
in the Company's Annual Report.
NOTE B -- ADVERTISING AND PROMOTIONAL EXPENDITURES
Prepaid promotional expenditures consist of deposits made for direct
advertising to be mailed in future periods and prepaid amounts for Internet
advertising. Direct mail promotional costs are recorded as expenses during the
period in which the promotional materials are mailed. Internet advertising is
expensed on a straight-line basis over the periods in which the advertising
takes place. During the quarter ended March 31, 2001, the Company negotiated a
reduction of $200,000 for amounts due under the Internet advertising program.
Under the Internet advertising program, the Company has commitments of
approximately $500,000 pursuant to terms and conditions of the agreements.
NOTE C -- INVENTORIES
Inventories are stated at the lower of cost (using the first-in, first-out
method) or market. Inventories consist primarily of preloaded cameras, film and
photofinishing supplies.
NOTE D -- RECLASSIFICATIONS
Certain prior year balances have been reclassified to conform to the
current year's presentation.
NOTE E -- SEGMENT REPORTING
The Company currently operates in one principal business segment.
Page 7 of 17
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE F -- INCOME TAXES
In the second quarter of fiscal 2000, it was determined that due to the
Company's continued focus on promotional activities related to its digital
imaging and online services and the effects of such costs on its ongoing
profitability, it was appropriate to provide a valuation allowance equal to the
amount of deferred tax assets not recoverable through operating loss carrybacks.
For the six months ended March 31, 2001 the income tax benefit was $0, as
opposed to a benefit of approximately $3,442,000 (assuming a normal statutory
rate of 34%). Utilization of the remaining deferred tax assets of approximately
$16,335,000 is dependent on future profits that are not assured.
NOTE G -- EARNINGS PER SHARE
The Company calculates earnings per share in accordance with the Financial
Accounting Standards Board Statement of Financial Accounting Standards No. 128,
"Earnings per Share". Net loss per share is based on the weighted average number
of common shares outstanding. Convertible preferred shares, outstanding warrants
and stock options to purchase shares of common stock were excluded from the
computation of earnings per share because their effect was antidilutive.
The following table sets forth the computation of loss per share:
Second Quarter Ended Six Months Ended
-------------------------------- --------------------------------
March 31, 2001 March 25, 2000 March 31, 2001 March 25, 2000
=============== =============== =============== ===============
Numerator for basic and diluted earnings per share:
Net loss $(6,896,000) $(4,791,000) $(9,929,000) $(5,263,000)
Preferred stock accretion - (1,035,000) - (1,035,000)
----------- ----------- ----------- -----------
Loss attributable to common shareholders (6,896,000) (5,826,000) (9,929,000) (6,298,000)
=========== =========== =========== ===========
Denominator:
Weighted-average number of common shares 16,522,000 16,368,000 16,514,000 16,347,000
=========== =========== =========== ===========
Net loss per share $ (.42) $ (.29) $ (.60) $ (.32)
=========== =========== =========== ===========
Net loss per commons share $ (.42) $ (.36) $ (.60) $ (.39)
=========== =========== =========== ===========
NOTE H -- CONTINGENCIES
The Company is a defendant in a legal proceeding that was filed by Fuji
Photo Film Co., Ltd. with the International Trade Commission in February 1998.
The action was filed against a number of importers, including the Company's
OptiColor, Inc. subsidiary, alleging patent infringement of U.S. patents held by
Fuji on single use cameras through the importation and resale of recycled
cameras. Fuji was seeking an order prohibiting importation of infringing cameras
into the U.S. and prohibiting further sales of such products which had been
imported. Sales of recycled cameras accounted for 4.3% and 4.1% of the Company's
net revenues during fiscal 2000 and 1999, respectively. After an evidentiary
hearing before an ITC Administrative Law Judge in November 1998, the ITC
Commissioners issued a final order in June 1999 prohibiting the Company and its
subsidiaries from importing and selling imported recycled single use cameras.
The Company has appealed the ITC Commissioners' order to the Federal Circuit
Court of Appeals. In the appeal, as in the ITC proceeding, the issues have been
and are vigorously contested.
Page 8 of 17
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE H -- CONTINGENCIES (Continued)
A complaint was filed in March 2000, since twice amended, against the
Company, by six individual plaintiffs suing on their own behalf and purportedly
on behalf of a class of all private citizens and non-governmental entities who
had received from the Company, and had the Company process, "C-41" 35mm color
film from the Company or who had received replacement rolls of film from the
Company after film processing. This complaint alleged that the Company had
engaged in unfair and deceptive practices by allegedly misrepresenting that film
received from the Company must be processed only by the Company and that
replacement film is "free". On April 24, 2001, without admitting wrongdoing or
liability, and for the sole purpose of compromising disputed claims and avoiding
costs and risks of further litigation, PhotoWorks and the plaintiffs who
represent the Class agreed to a proposed settlement. PhotoWorks agreed with
class representatives to settle the lawsuit for agreements regarding future
business conduct, distribution of film and discount coupons to the public, and
disclosure of film processing information. Pursuant to the agreement and Court
order, a summary of the terms of settlement was published in the USA Today on
May 7, 2001 and was posted on a website referred to in that publication. The
settlement is subject to final Court approval.
As part of the settlement, PhotoWorks will provide these benefits to Class
Members: (1) Within one year PhotoWorks will make the following distributions of
free rolls of 24-exposure standard C-41 film: (a) It will distribute an
aggregate of 900,000 rolls to persons who are active PhotoWorks customers, with
the identity of recipients and number of rolls per recipient (not to exceed
three) determined by PhotoWorks in a way that reasonably takes into account past
and/or anticipated quantity or frequency of their transactions; (b) It will also
distribute one roll to each of the first 300,000 Class Members who request the
roll within six months of the notice, and who do not receive any of the 900,000
rolls above. Materials accompanying these distributions will inform recipients
that the C-41 process identified on the film is an industry standard chemical
process that most photo-processing labs use to develop film. (2) Each member of
the Class who does not receive free film under (1) above may submit to
PhotoWorks a Coupon appended or attached to the Notices (prior to the Coupon's
expiration) to receive a $1 discount on a film processing order.
In addition, PhotoWorks will pay (subject to Court approval) $2,500 to each
of the named plaintiffs/class representatives as compensation for their time and
involvement in the Class Suit, and $320,000 to the attorneys for the Class for
their services and costs in the Class Suit. A total of $335,000 was booked to
other expense in the quarter ended March 31, 2001.
The Company does not believe the terms of the settlement agreement will
have a material adverse effect on its financial position or overall trends in
the results of operations.
The Company is also involved in various routine legal proceedings in the
ordinary course of its business.
NOTE I -- SUBSEQUENT EVENT
On April 25, 2001, the Company closed a $2,500,000 Subordinated Debenture
financing with investment advisory clients of Zesiger Capital Group, LLC. The
subordinated debentures have a 7% interest rate and are convertible at the
discretion of the holders, into Series B Preferred Stock at a conversion price
of $75.00 per share, one year after closing. Each share of Series B Preferred
Stock is convertible, at the option of the holder, at any time into 100 shares
of Common Stock (Series B conversion to common stock results in $.75 per common
share). If not previously converted, the debentures will be repaid five years
from closing.
NOTE J -- ADOPTION OF ACCOUNTING STANDARDS
The Company adopted Statement of Financial Accounting Standards No. 133
("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities," in
the first quarter of fiscal year 2001. The Standard requires the Company to
recognize all derivatives on the balance sheet at fair value. The adoption of
SFAS 133 is not expected to have a material effect on the Company's financial
position or overall trends in the results of operations.
Page 9 of 17
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Safe Harbor Statement under the Private Securities Litigation Reform Act of
1995:
This report contains forward-looking statements that relate to future
events, product or service offerings or the future financial performance of the
Company. In some cases, you can identify forward-looking statements by
terminology such as "may," "will," "should," "expects," "plans," "anticipates,"
"believes," "estimates," "predicts," "potential," or "continue" or the negative
of such terms and other comparable terminology. These statements only reflect
the Company's management's expectations and estimates. Actual events or results
may differ materially from those expressed or implied by such forward-looking
statements due to a number of known and unknown risks and uncertainties. These
risks and uncertainties include the inability to convert the bank line of credit
to a one-year revolving line of credit, inability to successfully achieve
operational plans and marketing initiatives, possibility of delays in the
expansion of image storage capacity due to delays in deliveries from suppliers
or technical problems; system performance problems due to technical
difficulties, system malfunctions, Internet interruptions or other factors;
pricing and other activities by competitors; and other risks including those
described in the Company's Annual Report on Form 10-K and those described from
time to time in the Company's other filings with the Securities and Exchange
Commission, press releases and other communications. Any forward-looking
statements in this report reflect the Company's expectations at the time of this
report only, and the Company disclaims any responsibility to revise or update
any such forward-looking statements except as may be required by law.
General
PhotoWorks, Inc. ("PhotoWorks" or the "Company") is a leading online,
direct mail and retail photo services company dedicated to providing customers
with innovative ways to create and tell the stories of their lives through
photos. PhotoWorks is a direct-to-consumer provider of film and image
processing and online image storage and management services. The Company offers
an array of complementary services and products primarily under the brand names
PhotoWorks(R) and Seattle FilmWorks(R).
To promote its services and products, the Company relies primarily on
direct-marketing and online e-mail programs. The Company continually tests and
refines its offers in an effort to improve its effectiveness and reach a broader
market. Offers designed to showcase the PhotoWorks(R) services may include
introductory pricing, film or other offers. In past years, the Company primarily
relied on an introductory film offer and free processing to first time customers
to introduce potential customers to PhotoWorks products and services. The
Company's introductory offers have been advertised through direct-response
media, print media, and national advertising campaigns. The Company also
promotes its introductory offers on its Web site (www.photoworks.com). In
addition, the Company has a customer referral program for online and mail order
customers which encourages existing customers to suggest family and friends that
may be interested in the Company's services and products. The Company also
partners with other Internet companies to broaden the marketing of its
PhotoWorks' services by providing customers with new and interesting ways to
share their photos.
Since 1978, the Company has been an industry leader in the introduction of
value-added photo-related services and products and has continued this tradition
by launching its online image management service, PhotoWorks(R) in April 1999.
The Company offers prints, slides, digital images and online archiving, all from
the same roll of 35mm film. PhotoWorks can process any brand of 35mm film,
Advanced Photo Systems (24mm) film or 35mm single-use camera. PhotoWorks was
among the first to provide express-mail delivery, cross-referenced data on
prints and negatives, a composite photo index and a convenient reorder system.
To a lesser extent, the Company provides products and supplies on a wholesale
basis.
Page 10 of 17
Since 1994, the Company has been a pioneer in providing digital-imaging
technologies which enable photofinishing customers to share personal photographs
with friends and family. Products incorporating these technologies include (i)
Pictures On Disk(TM) a floppy disk containing digital images from a roll of
film; (ii) PhotoWorks(R) software, which can be used to create digital
photograph albums and screen savers and; (iii) Pictures On Disk(TM) on CD, a CD
containing digital images from a roll of film. In April 1999, the Company
introduced PhotoWorks(R), an online image management system which enables
customers to view, share, archive and order reprints and organize their photos
online. Other recent products include PhotoWorks(R) Albums, an online tool to
easily create and share photo albums, PhotoWorks(R) Cards, an online service
which allows customers to create personalized greeting cards using their
favorite photos, and an assortment of personalized photo gifts. In April 2001,
the Company launched PhotoDVD(TM), a new product that puts customers' photos on
media format DVD. PhotoDVD allows customers to enjoy their favorite photos on
television. The Company expects to continue to introduce products in 2001 which
will provide traditional and digital camera users with a simple and convenient
way to store, print and use their online digital images. In addition, the
Company has partnered with other Internet-related companies to broaden the
marketing of its PhotoWorks services and provide customers with new and
interesting ways to share their photos.
The net loss for the first six months of fiscal 2001 was $9,929,000 or a
loss of $.60 per share, compared to a net loss of $5,263,000 or a loss of $.32
per share for the first six months of fiscal 2000. Operating results will
fluctuate in the future due to changes in the mix of sales, promotional
activities, price increases by suppliers, introductions of new products,
research and development requirements, actions by competitors, foreign currency
exchange rates, conditions in the direct-to-consumer market and the
photofinishing industry in general, national and global economic conditions and
other factors.
Demand for the Company's photo-related services and products is seasonal,
with the highest volume of photofinishing activity occurring during the summer
months. However, seasonality of demand may be offset by the introduction of new
services and products, changes in the level of effectiveness of customer
acquisition programs, activities by competitors, production difficulties and
other factors. This seasonality has generally produced greater photofinishing
net revenues during the last half of the Company's fiscal year (April through
September), with a peak occurring in the fourth fiscal quarter. Net income is
affected by the seasonality of the Company's net revenues due to the fixed
nature of a portion of the Company's operating expenses, seasonal variation in
sales mix and the Company's practice of incurring relatively higher marketing
program expenditures prior to the summer months.
Results of Operations
The following table presents information from the Company's consolidated
statements of operations, expressed as a percentage of net revenues for the
periods indicated.
Second Quarter Ended Six Months Ended
--------------------- ---------------------
March 31, March 25, March 31, March 25,
2001 2000 2001 2000
========= ========= ========= =========
Net revenues 100.0% 100.0% 100.0% 100.0%
Cost of goods and services 86.3 71.9 84.0 68.6
------ ------ ----- ------
Gross profit 13.7 28.1 16.0 31.4
Operating expenses:
Marketing expenses 41.0 40.0 28.1 35.2
Research and development 10.6 3.3 9.1 2.8
General and administrative 16.4 9.5 14.2 7.7
------ ------ ----- ------
Total operating expenses 68.0 52.8 51.4 45.7
------ ------ ----- ------
Loss from Operations (54.3) (24.7) (35.4) (14.3)
Total other income (expense) - 1.8 (.5) 1.5
------ ------ ----- ------
Loss before income taxes (54.3) (22.9) (35.9) (12.8)
Provision for income taxes - (2.6) - (.6)
------ ------ ----- ------
Net loss (54.3)% (25.5)% (35.9) (13.4)%
====== ====== ===== ======
Page 11 of 17
Net revenues for the second quarter of fiscal 2001 were $12,690,000 as
compared to net revenues of $18,796,000 in the second quarter of fiscal 2000.
For the six months ended March 31, 2001, net revenues were $27,675,000 compared
to $39,287,000 for the same period of fiscal 2000. The decline in net revenues
is primarily due to significantly lower processing volumes combined with an
overall decrease in the revenue per roll as compared to the prior year periods.
Management believes processing volumes decreased primarily due to lower
marketing expenditures combined with an overall softness in the photofinishing
industry. The decline in revenue per roll is a result of aggressive pricing and
competition in the online photo space.
Cost of goods and services consist of labor, postage, supplies and fixed
operating costs related to the Company's services and products. Gross profit in
the second quarter of fiscal 2001 decreased to 13.7% of net revenues compared to
28.1% in the second quarter of fiscal 2000. For the first six months of fiscal
2001, gross profit decreased to 16.0% compared to 31.4% for the same period of
fiscal 2000. The decline in gross margin is primarily due to declines in
revenues per roll, as discussed above, as well as fixed operating costs related
to equipment, facilities, and overhead costs, including increased depreciation
and lease costs for archiving equipment. Fluctuations in gross profit will occur
in future periods due to the seasonal nature of revenues, mix of product sales,
level and nature of marketing activities and other factors.
Total operating expenses in the second quarter of fiscal 2001 decreased to
$8,637,000 compared to $9,930,000 in the second quarter of fiscal 2000. For the
first six months of fiscal 2001, total operating expenses decreased to
$14,227,000 compared to $17,937,000 for the same period of fiscal 2000. The
decrease in operating expenses was primarily due to a reduction in marketing
expenses, partially offset by increased costs related to research and
development, information technology and general and administrative. Future
periods may reflect increased or decreased operating costs due the timing and
magnitude of marketing activities and research and development activities.
Marketing expenses include current period expenses associated with customer
acquisition, building brand awareness, testing of new marketing strategies and
marketing to existing customers. Marketing expenses in the second quarter of
fiscal 2001 decreased to $5,199,000 compared to $7,516,000 in the second quarter
of fiscal 2000. For the first six months of fiscal 2001, marketing expenses
decreased to $7,765,000 compared to $13,823,000 for the same period in fiscal
2000. The fiscal 2000 marketing expenses included costs associated with a major
marketing campaign to promote the Company's PhotoWorks brand and introduce its
online services and products. The campaign included national print and media
advertising combined with direct marketing mailings. Marketing expenditures in
fiscal 2001 were lower primarily due to the Company's testing of programs to
target its traditional and former customer databases through retention and
reactivation marketing programs. The Company has been evaluating marketing
programs that focus on more immediate returns on investment and plans to target
its customer database through targeted and cost effective promotions. During the
quarter ended March 31, 2001, the Company renegotiated with certain of its
Internet partners to reduce the cash and promotional obligations related to the
agreements that resulted in non-cash charges of approximately $513,000 for the
quarter. Marketing expenditures for fiscal 2001 are expected to be significantly
lower as compared to fiscal 2000. Each year the Company prepares detailed plans
for its various marketing activities, including the mix between customer
acquisition and other marketing programs. However, the Company occasionally
changes both the mix and total marketing expenditures between periods to take
advantage of marketing opportunities as they become available.
Research and development expenses increased to $1,350,000 for the second
quarter of fiscal 2001 compared to $618,000 in the second quarter of fiscal
2000. For the first six months of fiscal 2001, research and development costs
increased to $2,525,000 as compared to 1,083,000 for the same period of fiscal
2000. The increase was due primarily to additional personnel hired to support
research and development for PhotoWorks(R) online archiving, photo sharing
services and development of new products and services. Research and development
expenses consist primarily of costs incurred in the development and enhancement
of its PhotoWorks(R) service, Internet and other online digital services and
products.
General and administrative expenses increased to $2,088,000 for the second
quarter of fiscal 2001 compared to $1,796,000 for the second quarter of fiscal
2000. For the six months ended March 31, 2001, general and administrative
expenses increased to $3,937,000 compared to $3,031,000 for the same period of
fiscal 2000. The increase is primarily a result of increased expenditures
related to information systems to support the Company's computer-based and
Internet-related operations. General and administrative costs were also higher
due to increased costs associated with legal fees, wages,
Page 12 of 17
recruiting, and shareholder relations. General and administrative expenses
consist of costs related to computer operations, human resource functions,
finance, legal, accounting, investor relations and general corporate activities.
During the quarter ended March 31, 2001 the Company reached an out of court
settlement related to its processing and film offers (See Note H -
Contingencies) which resulted in a charge to other expense in the amount of
$335,000. The settlement is still subject to final approval by the Court. The
Company also wrote off $236,000 of fixed assets that are no longer in use due to
lower processing volumes and production changes. In addition, the Company
recorded other income of approximately $675,000 for a reduction in an amount due
under notes payable. The reduction of the note was the result of renegotiation
of amounts charged for certain advertising services in fiscal year 2000.
Liquidity and Capital Resources
As of May 4, 2001, the Company's principal sources of liquidity included
$3,310,000 in cash. The cash balance as of May 4, 2001, includes $2.5 million of
new financing that closed on April 25, 2001 (as noted below). Although the
Company does not currently have any fixed material commitments with regard to
capital expenditures it expects to spend approximately $400,000 during the
remainder of fiscal 2001, principally for data storage and computer network
equipment and photofinishing equipment.
During the first six months of fiscal 2001, the Company had negative cash
flow from operations of approximately $4.3 million. Cash and securities
available-for-sale declined to $531,000 as of March 31, 2001 and the Company's
current ratio declined to .5. Subsequent to the period ended March 31, 2001, the
Company secured new financing in the amount of $2.5 million as discussed below.
During fiscal 2000, a substantial portion of marketing expenses were
incurred for brand advertising and customer acquisition that was undertaken
pursuant to the Company's corporate name change. Marketing expenditures in
fiscal 2000 were heavily focused on establishing a leadership position in the
online photo space combined with rebranding and renaming the company from
Seattle FilmWorks to PhotoWorks. The Company does not anticipate this level of
marketing and advertising expenditures in future periods. Additionally, the
Company expects to reduce direct marketing expenditures by utilizing more
efficient communications with customers. In November 2000 and March 2001, the
Company realigned its organizational structure and reduced its workforce by a
total of approximately 25%.
The Company negotiated a reduction of approximately $675,000 in the amount
due under a note payable. The reduction related to amounts charged for certain
advertising services in fiscal year 2000. As part of the renegotiation of the
note, a payment of $1.1 million is due May 15, 2001, and a payment of $167,000
is due on June 4, 2001.
On April 25, 2001, the Company closed a $2,500,000 Subordinated Debenture
financing with investment advisory clients of Zesiger Capital Group, LLC. The
subordinated debentures have a 7% interest rate and are convertible at the
discretion of the holders, into Series B Preferred Stock at a conversion price
of $75.00 per share, one year after closing. Each share of Series B Preferred
Stock is convertible, at the option of the holder, at any time into 100 shares
of Common Stock (Series B conversion to common stock results in $.75 per common
share). If not previously converted, the debentures will be repaid five years
from closing.
In addition to the above operational plans, the Company has a $2.5 million
bank line of credit that management believes can be converted to a one-year
revolving line of credit. The bank line of credit is currently due May 31, 2001.
The Company is actively seeking additional financing and has a signed term sheet
for additional capital that is currently under legal review. Management believes
that, under its current operational and financing plans outlined above, current
cash balance, recent financing, and estimated future cash flows, the Company
will have sufficient funds for operations through at least the next twelve
months. However, the Company's inability to convert the $2.5 million bank line
of credit to a revolving line of credit, or generate cash flow from operations
would have a material adverse impact on the Company's financial position and
liquidity which may require the Company to further reduce its expenditures, seek
additional capital or refinance its obligations to enable it to continue
operations. There can be no assurance that the Company will be able to obtain
adequate financing in the future.
Page 13 of 17
PART II -- OTHER INFORMATION
----------------------------
ITEM 1 - LEGAL PROCEEDINGS
For an update concerning the legal proceeding filed by Fuji Photo Film Co.,
Ltd. On February 13, 1998, and the class action filed on March 29, 2000, see
Note H of notes to Consolidated Financial Statements in Part I above.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS
On February 6, 2001, the Company held its annual meeting of shareholders.
The shareholders acted on the following matters at the annual meeting.
The following individual was elected to the Company's Board of Directors,
to hold office for a three-year term and until his respective successor is duly
elected and qualified. The number of votes cast, the number of votes withheld,
and the number of broker non-votes are listed below.
For Withheld Non-votes
--- -------- ---------
Howard Lee 18,441,828 129,115 N/A
The following individuals were elected to the Company's Board of Directors,
to hold office for a two-year term and until his respective successor is duly
elected and qualified. The number of votes cast, the number of votes withheld,
and the number of broker non-votes are listed below.
For Withheld Non-votes
--- -------- ---------
Matthew A. Kursh 18,442,584 128,359 N/A
Douglas A. Swerland 18,439,010 131,933 N/A
The following individuals were elected, by the Preferred shareholders, to
the Company's Board of Directors to hold office for a three-year term and until
his respective successor is duly elected and qualified. The number of votes
cast, the number of votes withheld, and the number of broker non-votes are
listed below.
For Withheld Non-votes
--- -------- ---------
Ross K. Chapin 3,157,895 0 N/A
Paul B. Goodrich 3,157,895 0 N/A
The amendment to the PhotoWorks 1999 Stock Incentive Compensation Plan to
increase the number of shares of the Company's Common Stock reserved for
issuance thereunder from 800,000 shares to 1,300,000 shares was approved. The
number of votes cast, the number of votes withheld, and the number of broker
non-votes are listed below.
For Withheld Non-votes Other Unvoted
--- -------- --------- -------------
16,580,246 1,935,938 54,759 1,092,611
Page 14 of 17
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
10.1 Supplemental lease agreement No. 8 with General Services
Administration effective February 1, 2001
(b) Reports on Form 8-K.
Form 8-K dated April 25, 2001 - Item 5 - Other Events related to the
Company's closing of a $2,500,000 Subordinated Debenture financing.
Page 15 of 17
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PHOTOWORKS, INC.
DATED: May 14, 2001 /s/ Howard Lee
-----------------------------------------
Howard Lee
President/Chief Executive Officer
(Principal Executive Officer)
/s/ Loran Cashmore Bond
-----------------------------------------
Loran Cashmore Bond
Treasurer/Chief Accounting Officer
Page 16 of 17
INDEX TO EXHIBITS
PHOTOWORKS, INC.
Quarterly Report on Form 10-Q
For The Quarter Ended March 31, 2001
Exhibit Description Page No.
- ------- ----------- --------
10.1 Supplemental lease agreement No. 8 with General Service
Administration effective February 1, 2001 18
Page 17 of 17