- -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED OCTOBER 31, 1998 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: 0-14082 MERRILL CORPORATION (Exact name of Registrant as specified in its charter) MINNESOTA 41-0946258 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) ONE MERRILL CIRCLE ST. PAUL, MINNESOTA 55108 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: 651-646-4501 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 filing requirements for the past 90 days. Yes X No -------- -------- The number of shares outstanding of Registrant's Common Stock, par value $.01, on December 11, 1998 was 16,096,355. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PART I.--FINANCIAL INFORMATION PAGE(S) ----------- ITEM 1. FINANCIAL STATEMENTS Included herein is the following unaudited financial information: Consolidated Balance Sheets as of October 31, 1998 and January 31, 1998.............................. 3 Consolidated Statements of Operations for the three and nine month periods ended October 31, 1998 and 1997................................................................................................ 4 Consolidated Statements of Cash Flows for the nine month periods ended October 31, 1998 and 1997..... 5 Notes to Consolidated Financial Statements........................................................... 6 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS........... 7-10 PART II.--OTHER INFORMATION PAGE(S) ----------- ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K................................................................ 11 SIGNATURES............................................................................................... 12 2 MERRILL CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA) ASSETS OCTOBER 31, JANUARY 31, 1998 1998 ----------- ----------- (UNAUDITED) Current assets Cash and cash equivalents.......................................................... $ 5,663 $ 2,531 Trade receivables, less allowance for doubtful accounts of $8,449 and $6,992, respectively..................................................................... 116,547 116,721 Work-in-process inventories........................................................ 14,305 13,686 Other inventories.................................................................. 9,226 7,112 Other current assets............................................................... 12,400 10,290 ----------- ----------- Total current assets............................................................. 158,141 150,340 Property, plant and equipment, net................................................... 43,749 41,045 Goodwill, net........................................................................ 42,385 44,437 Other assets......................................................................... 12,992 10,657 ----------- ----------- Total assets..................................................................... $ 257,267 $ 246,479 ----------- ----------- ----------- ----------- LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities Current maturities of long-term debt............................................... $ 2,710 $ 655 Current maturities of capital lease obligations.................................... 221 249 Accounts payable................................................................... 28,301 29,142 Accrued expenses................................................................... 34,644 41,033 ----------- ----------- Total current liabilities........................................................ 65,876 71,079 Long-term debt, net of current maturities............................................ 38,110 40,225 Capital lease obligations, net of current maturities................................. 1,446 1,616 Other liabilities.................................................................... 8,455 7,884 ----------- ----------- Total liabilities................................................................ 113,887 120,804 ----------- ----------- Shareholders' equity Common stock, $.01 par value: 25,000,000 shares authorized; 16,177,755 and 16,315,136 shares, respectively, issued and outstanding.......................... 162 163 Undesignated stock: 500,000 shares authorized; no shares issued.................... Additional paid-in capital......................................................... 17,882 22,401 Retained earnings.................................................................. 125,336 103,111 ----------- ----------- Total shareholders' equity....................................................... 143,380 125,675 ----------- ----------- Total liabilities and shareholders' equity....................................... $ 257,267 $ 246,479 ----------- ----------- ----------- ----------- The accompanying notes are an integral part of the consolidated financial statements. 3 MERRILL CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) (UNAUDITED) THREE MONTHS ENDED NINE MONTHS ENDED OCTOBER 31 OCTOBER 31 ----------------------------- --------------------------- 1998 1997 1998 1997 ------------ ------------ ------------ ------------ Revenue..................................................... $ 119,759 $ 112,091 $ 391,731 $ 337,551 Cost of revenue............................................. 80,659 72,717 250,299 213,526 ------------ ------------ ------------ ------------ Gross profit.............................................. 39,100 39,374 141,432 124,025 Selling, general and administrative expenses................ 26,403 28,481 97,095 85,755 ------------ ------------ ------------ ------------ Operating income.......................................... 12,697 10,893 44,337 38,270 Interest expense............................................ (984) (1,153) (3,011) (3,283) Other income (expense), net................................. (22) 351 487 449 ------------ ------------ ------------ ------------ Income before provision for income taxes.................. 11,691 10,091 41,813 35,436 Provision for income taxes.................................. 5,203 4,384 18,607 15,663 ------------ ------------ ------------ ------------ Net income................................................ $ 6,488 $ 5,707 $ 23,206 $ 19,773 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ Net income per share: Basic..................................................... $.40 $.35 $1.42 $1.23 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ Diluted................................................... $.38 $.33 $1.35 $1.18 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ Dividends per common share.................................. $.02 $.02 $ .06 $ .05 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ Weighted average number of shares outstanding: Basic..................................................... 16,264,995 16,258,722 16,336,743 16,068,965 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ Diluted................................................... 16,982,401 17,208,345 17,160,710 16,793,500 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ The accompanying notes are an integral part of the consolidated financial statements. 4 MERRILL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) NINE MONTHS ENDED OCTOBER 31 ------------------------ 1998 1997 ---------- ---------- Operating activities Net income........................................................................... $ 23,206 $ 19,773 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization...................................................... 9,134 7,950 Amortization of intangible assets.................................................. 3,309 3,052 Writedown of goodwill.............................................................. 1,000 Provision for losses on trade receivables.......................................... 3,458 3,002 Deferred compensation.............................................................. 1,724 1,139 Changes in operating assets and liabilities, net of effects from business acquisitions Trade receivables................................................................ (2,572) (26,000) Work-in-process inventories...................................................... (619) 4,243 Other inventories................................................................ (2,114) (763) Other current assets............................................................. (635) (1,286) Accounts payable................................................................. (1,686) 3,005 Accrued expenses................................................................. (7,413) 4,978 Accrued and deferred income taxes................................................ (1,372) (4,911) ---------- ---------- Net cash provided by operating activities...................................... 25,420 14,182 ---------- ---------- Investing activities Business acquisitions, net of cash acquired.......................................... (3,230) (10,390) Purchase of property, plant and equipment............................................ (11,361) (12,716) Other, net........................................................................... (1,938) (627) ---------- ---------- Net cash used in investing activities.......................................... (16,529) (23,733) ---------- ---------- Financing activities Borrowings on notes payable to banks................................................. 86,600 92,025 Repayments on notes payable to banks................................................. (86,600) (88,175) Principal payments on long-term debt and capital lease obligations................... (258) (354) Repurchase of common stock........................................................... (6,585) (3,065) Dividends paid....................................................................... (981) (807) Exercise of stock options............................................................ 1,832 5,327 Tax benefit realized upon exercise of stock options.................................. 785 2,141 Other equity transactions, net....................................................... (552) 79 ---------- ---------- Net cash (used in) provided by financing activities............................ (5,759) 7,171 ---------- ---------- Increase (decrease) in cash and cash equivalents....................................... 3,132 (2,380) Cash and cash equivalents, beginning of period......................................... 2,531 5,161 ---------- ---------- Cash and cash equivalents, end of period............................................... $ 5,663 $ 2,781 ---------- ---------- ---------- ---------- The accompanying notes are an integral part of the consolidated financial statements. 5 MERRILL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. ACCOUNTING POLICIES The consolidated financial statements as of October 31, 1998, and for the three and nine month periods ended October 31, 1998 and 1997, have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. The consolidated financial statements reflect all adjustments, consisting of normal recurring accruals, which the Company considers necessary for a fair presentation of the results for the indicated periods. Certain information and accounting policies and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's 1998 Annual Report. 2. NET INCOME PER SHARE Effective January 31, 1998, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 128 "Earnings Per Share," and has disclosed basic and diluted net income per share for the three and nine month periods ended October 31, 1998 and 1997, in accordance with the Standard. The denominator used to calculate diluted earnings per share includes the dilutive impact of stock options, which increase the actual weighted average number of shares outstanding by 717,406 and 949,623 for the three month periods ended October 31, 1998 and 1997, respectively and by 823,967 and 724,535 for the nine month periods ended October 31, 1998 and 1997, respectively. 3. SHAREHOLDERS' EQUITY The Company repurchased 238,700 shares of its common stock for approximately $4.4 million during the third quarter of fiscal year 1999. A total of 338,700 shares for approximately $6.6 million have been repurchased in fiscal year 1999 and a cumulative total of 602,700 shares have been repurchased under the 1,500,000 authorized share repurchase program approved by the Board of Directors during fiscal year 1997. 4. BUSINESS ACQUISITIONS On June 15, 1998, the Company completed an acquisition under which the Company received substantially all operating assets and assumed certain liabilities of Executech, Inc. and an affiliated company, World Wide Scan Services, LLC, for cash consideration of $3.2 million. In addition, the agreement requires the Company to pay additional cash consideration some of which is based on future performance of Executech, Inc. and World Wide Scan Services, LLC. 6 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements in Management's Discussion and Analysis of Financial Condition and Results of Operations, constitute 'forward-looking' statements within the meaning of the federal Securities laws. Such 'forward-looking' statements involve known and unknown risks, uncertainties, or achievements of the Company which may cause actual results to be materially different from any future results, performance, or achievements expressed or implied by such 'forward-looking' statements. These risks and uncertainties include, but are not limited to, the effect of economic and financial market conditions, government public reporting regulations, paper costs and the integration and performance of recent acquisitions. RESULTS OF OPERATIONS The following table sets forth the percentage relationship to total revenue of certain items in the Company's consolidated statements of operations for the three and nine month periods ended October 31, 1998 and 1997, and the percentage change in the dollar amounts of such items between the periods. THREE MONTHS ENDED OCTOBER 31, NINE MONTHS ENDED OCTOBER 31, ------------------------------------ --------------------------------------- PERCENTAGE PERCENTAGE INCREASE INCREASE PERCENTAGE (DECREASE) PERCENTAGE (DECREASE) OF REVENUE ---------- OF REVENUE ---------- --------------------- 1998 VS. ------------------------ 1998 VS. 1998 1997 1997 1998 1997 1997 -------- -------- ---------- -------- -------- ---------- Revenue Financial.................................. 33.5% 37.3% (4)% 37.6% 36.8% 19% Corporate.................................. 31.1 32.8 1 32.4 34.1 10 Commercial and other....................... 21.5 18.7 23 18.4 18.0 19 Document management services............... 13.9 11.2 33 11.6 11.1 22 -------- -------- -------- -------- Total revenue............................ 100.0 100.0 7 100.0 100.0 16 Cost of revenue.............................. 67.4 64.9 11 63.9 63.3 17 -------- -------- -------- -------- Gross profit............................. 32.6 35.1 (1) 36.1 36.7 14 Selling, general and administrative expenses.................................... 22.1 25.4 (7) 24.8 25.4 13 -------- -------- -------- -------- Operating income......................... 10.5 9.7 17 11.3 11.3 16 Interest expense............................. (0.8) (1.0) (15) (0.8) (1.0) (8) Other income (expense), net.................. -- 0.3 (106) 0.2 0.2 8 -------- -------- -------- -------- Income before provision for income taxes.................................. 9.7 9.0 16 10.7 10.5 18 Provision for income taxes................... 4.3 3.9 19 4.8 4.6 19 -------- -------- -------- -------- Net income............................... 5.4% 5.1% 14 5.9% 5.9% 17 -------- -------- -------- -------- -------- -------- -------- -------- QUARTER ENDED OCTOBER 31, 1998 COMPARED TO QUARTER ENDED OCTOBER 31, 1997 Revenue for the third quarter of fiscal year 1999 increased by $7.7 million or 7% to $119.8 million. The financial revenue category decreased 4% in the third quarter compared to the prior year's third quarter. The third quarter decline in transaction revenue partially reflects the sharp decline in market activity during the late summer and early fall timeframe. The fall market volatility dropped the transaction deal activity more than 50 percent from summer levels. The third quarter decline is primarily represented by reduced financial transaction activity in the June to August timeframe. We expect to experience most of the effect of the late summer and fall market downturn in our fourth quarter and possibly the first quarter of our next fiscal year. The corporate revenue category increased 1% compared to the same period last year. Our corporate compliance work, (10Ks, 10Qs and proxies) decreased in the third quarter from timing of work completion in earlier quarters of fiscal year 1999 when compared to fiscal year 1998. Investment Company Services sector revenue continued its strong growth driven by increased revenue from existing 7 customers and the addition of five major new clients this year. The 23% revenue increase in the commercial and other revenue category is primarily attributable to the Managed Communications Programs sector, which had revenue growth of 18%. The growth was led by increased activity with Cendant Corporation under our preferred vendor agreements. There was also election-year ballot production revenue that contributed to the third quarter growth in this revenue category. The document management services revenue increased 33% in the third quarter. Leading the growth was a 45% increase in reprographics revenue, with approximately half of this growth the result of our second quarter acquisition of Executech, Inc. Document service center revenue growth was 19% for the third quarter, with same site revenue increases of 11%. Gross profit margin in the third quarter of fiscal year 1999 declined to 32.6% from 35.1% in the third quarter of fiscal year 1998. The weakening financial transaction market and lower production volume in our financial and corporate revenue categories contributed to this decreased margin. A significant portion of our cost structure is fixed and thus lower utilization of our production facilities in the third quarter of fiscal year 1999 impacted gross profit margin. Selling, general and administrative expenses decreased in the quarter compared to the prior year period. The overall decrease in expenses is attributable to lower selling and marketing costs and reduced incentive compensation expenses to reflect our revised profitability expectations for the full fiscal year offset by an increase in the provision for losses on trade receivables. The prior year quarter included higher provisions for incentive compensation based on profit expectations and continued expansion of sales and marketing activities offset by a decrease in the provision for losses on trade receivables. Interest expense declined in the third quarter compared to the same period last year and is mainly attributable to reduced interest costs associated with the Company's line of credit arrangement as a result of lower borrowing requirements for working capital in the current third quarter. The effective income tax rate for the third quarter increased 1.1% to 44.5%, compared to 43.4% in the same period a year ago. The increase in the rate resulted primarily from increased non-deductible business and entertainment expenses. Net income totaled $6.5 million, or 38 cents per diluted share, for the current quarter compared to $5.7 million, or 33 cents per diluted share, in the third quarter last year. Net income, as a percentage of revenue, increased primarily because of lower selling, general and administrative expenses as discussed previously. NINE MONTHS ENDED OCTOBER 31, 1998 COMPARED TO NINE MONTHS ENDED OCTOBER 31, 1997 Revenue for the nine months ended October 31, 1998 increased by $54.2 million or 16%, to $391.7 million. The financial revenue category increased by 19% as a result of the growth of financial market transactions through July 1998 offset by the decline in the third quarter as commented previously. The corporate revenue category increased by 10% with the increase from strong investment company services revenue and steady demand for corporate compliance work. Investment company services revenue has grown from existing as well as new clients. The 19% increase in commercial and other revenue was primarily the result of increased business generated by our Managed Communications Programs sector. The main drivers were increased activity with Cendant Corporation under our preferred vendor agreements, revenue from real estate products and services and election year ballot production work completed in the nine months. The document management services revenue category increased 22% from strong results in our contractual document service center business, which has increased 38% compared to the nine months, ended October 31, 1997. Contributions from our acquisition of Executech, Inc. in second quarter of fiscal year 1999 have also increased the revenue growth for the nine months. The overall sales growth contributed to a $17.4 million increase in gross profit. The gross profit margin was comparable to the prior year nine month period that also included strong overall volumes in our financial and corporate revenue categories and high utilization of our production facilities. 8 Selling, general and administrative expenses increased $11.3 million to $97.1 million. This increase is primarily a result of increased selling expenses in the first six months this year. In addition, general and administrative expenses increased because of a writedown of goodwill associated with Merrill Training and Technology, formerly Merrill/Superstar Computing Company during the first quarter of fiscal year 1999. Interest expense declined in the nine months compared to the same period last year and is mainly attributable to capitalizing interest on office remodeling. Other income (expense), net was consistent for the first nine months of fiscal year 1999 compared to fiscal year 1998. The primary contributors to other income are office rental income and the earnings related to the Quebecor Merrill Canada (QMC) joint venture, which is accounted for under the equity method of accounting. The effective income tax rate for the nine months increased .3% to 44.5%, compared to 44.2% for the same period a year ago. The effective income tax rate is higher than the federal statutory tax rate as a result of state income taxes, net of federal tax benefits, and non-deductible business and entertainment expenses. Net income totaled $23.2 million or $1.35 per diluted share, for the current nine month period compared to $19.8 million or $1.18 per diluted share, in the nine month period last year. Net income, as a percentage of revenue, was comparable for both periods. LIQUIDITY AND CAPITAL RESOURCES The Company continued to strengthen its financial position during fiscal year 1999. At October 31, 1998 working capital increased to $92.3 million from $79.3 million at January 31, 1998. The current ratio at October 31, 1998, was 2.4:1 compared with 2.1:1 at January 31, 1998. Working capital increased primarily from higher inventories and lower accruals for incentive compensation. The Company had net cash provided by operating activities of $25.4 million in the first nine months of fiscal year 1999 compared to net cash provided by operating activities of $14.2 million in the first nine months of fiscal year 1998. This change is driven principally by a decrease in accounts receivable and work-in-process inventories offset by decreases in accounts payable and accrued expenses. Net cash used in investing activities was $16.5 million and $23.7 million for the nine months ended October 31, 1998 and 1997, respectively. Capital expenditures during the first nine months of fiscal year 1999 approximated $11.4 million and were principally for reprographic and computer based production equipment and for leasehold improvements. Capital expenditures in the third quarter of fiscal year 1999 were down slightly from the second quarter. Net cash used in financing activities was $5.8 million compared to cash provided by financing activities of $7.2 million for the nine months ended October 31, 1998 and 1997, respectively. This change is primarily the result of repayment of borrowings under the Company's line of credit and repurchases of common stock offset by stock option exercises. Merrill Corporation has repurchased 338,700 shares of its common stock for approximately $6.6 million in fiscal year 1999 (238,700 shares for approximately $4.4 million in the third quarter). A cumulative total of 602,700 shares have been repurchased under the 1,500,000 authorized share repurchase program approved by the Board of Directors during fiscal year 1997. The Company regularly invests excess operating cash in overnight repurchase agreements that are subject to changes in short-term interest rates. Accordingly, the Company believes that the market risk arising from its holding of these financial instruments is minimal. YEAR 2000 READINESS Many older computer software programs refer to years in terms of their final two digits only. Such programs may interpret the year 2000 to mean the year 1900 instead. If not corrected, those programs 9 could cause date-related transaction failures. Merrill Corporation has a Year 2000 project underway that addresses our internal business systems including software, hardware and firmware as well as external business partners, supply chains, and customers. Our plan includes the following steps: - ASSESSMENT. We are identifying systems and individual components of systems that contain potentially corrupt computer codes. - REMEDIATION. We are making decisions on how to make systems and processes Year 2000-ready, then proceeding to make the necessary changes. - THIRD-PARTY VENDORS. We are surveying for Year 2000 readiness by material third-party vendors, including external providers of software and hardware products, as well as print producers. - CONFIGURATION MANAGEMENT. We track source code components of an application and changes to the components to manage the remediation process. - VALIDATION/TESTING. We are testing data and reviewing results to determine that errors were not introduced during the conversion process. - CONTINGENCY PLANNING. We are formulating contingency plans that address the continuum from minor administrative interruptions to failure of mission critical processes. Our project plan includes initial testing and remediation begun last year and continuing into the fourth quarter of the fiscal year ending January 31, 1999 ("fiscal 1999"). The Company also plans on completing the surveying of key suppliers in the fourth quarter of fiscal 1999. Based on those supplier surveys, the Company plans on developing contingency plans, if necessary, in the first quarter (April 30, 1999) of fiscal year 2000. We plan to ready Merrill's internal systems and electronic data links by first quarter (April 30, 1999) of the fiscal year ending January 31, 2000 ("fiscal 2000"), and resolution of any supplier problems by second quarter (July 31, 1999) of fiscal 2000. We have surveyed our major utility companies and have received some response statements. We are in the process of analyzing those statements and following up, where needed, for clarity. A master project plan has been developed and a Steering Committee meets regularly to monitor the plan and address issues. The project has progressed through the system assessment stage into the remediation stage where programming changes are being made to major business and production systems. The Company believes that the project is currently on schedule. The Company estimates that the total cost to identify and remediate Year 2000 problems is approximately $3.0 million. Approximately $750,000 of these costs have been incurred as of October 31, 1998. These costs are expensed as incurred. These costs are primarily consultant and payroll-related costs for the Company's information technology group and some computer hardware and software package upgrade purchase costs. Such costs do not include normal system upgrades and replacements. Detailed system-by-system status for major systems is available on our web site (http:// www.merrillcorp.com) for those interested parties. We, of course, do not have control over many Year 2000 problems. The nature of our society and the interconnected systems of government agencies, utilities, businesses and even individuals can affect our ability to provide goods and services to our customers, and by extension could also affect our financial position. We are making every effort to evaluate, correct, and test potential problem areas, but ultimately, the resolutions of Year 2000 questions by other entities in our network of relationships could influence us significantly. 10 PART II.--OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 27. Financial Data Schedule (b) Reports on Form 8-K None. 11 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. (REGISTRANT) MERRILL CORPORATION BY (SIGNATURE) /s/ John W. Castro (NAME AND TITLE) John W. Castro, President and Chief Executive Officer (DATE) December 15, 1998 BY (SIGNATURE) /s/ Kay A. Barber (NAME AND TITLE) Kay A. Barber, Chief Financial Officer (DATE) December 15, 1998 12 EXHIBIT INDEX EXHIBIT METHOD OF FILING - --------- ------------------------------- 27. Financial Data Schedule................................................ Filed herewith electronically