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: June 28, 2003 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 August 1, 2003, there were issued and outstanding 16,660,285 shares
of common stock, par value $.01 per share.
Index to Exhibits at Page 18
Page 1 of 21
PHOTOWORKS, INC.
INDEX
Page No.
--------
PART I -- FINANCIAL INFORMATION
Item 1 - Financial Statements 3-11
Consolidated Balance Sheets as of June 28, 2003
and September 28, 2002 3-4
Consolidated Statements of Operations for the third quarter
and nine months ended June 28, 2003 and June 29, 2002 5
Consolidated Statements of Cash Flows for the nine months
ended June 28, 2003 and June 29, 2002 6
Notes to Consolidated Financial Statements 7-11
Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations 12-15
PART II -- OTHER INFORMATION
Item 1 - Legal Proceedings 16
Item 5 - Controls and Procedures 16
Item 6 - Exhibits and Reports on Form 8-K 16
SIGNATURES 17
INDEX TO EXHIBITS 18
CERTIFICATIONS 19-21
Page 2 of 21
PART I -- FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
PHOTOWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
(UNAUDITED) (NOTE)
June 28, September 28,
ASSETS 2003 2002
===============================================================================================
CURRENT ASSETS
Cash and cash equivalents $ 4,585 $ 1,175
Income tax receivable (Note G) 107 1,808
Accounts receivable, net of allowance for doubtful accounts 72 548
Inventories 716 934
Prepaid expenses and other 401 4,011
------- -------
TOTAL CURRENT ASSETS 5,881 8,476
FURNITURE, FIXTURES, AND EQUIPMENT,
at cost, less accumulated depreciation 2,043 3,346
TOTAL ASSETS $ 7,924 $11,822
======= =======
Note: The September 28, 2002 consolidated balance sheet has been derived from
audited consolidated financial statements at that date included in the Company's
Annual Report on Form 10-K for the year ended September 28, 2002.
See notes to consolidated financial statements.
Page 3 of 21
PHOTOWORKS, INC.
CONSOLIDATED BALANCE SHEETS (continued)
(in thousands, except per share and share data)
(UNAUDITED) (NOTE)
June 28, September 28,
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) 2003 2002
=================================================================================================
CURRENT LIABILITIES
Accounts payable $ 1,583 $ 2,024
Accrued compensation 1,063 1,392
Accrued ITC penalty 1,600 --
Accrued taxes 150 150
Other accrued expenses 485 495
Deferred revenues 582 529
Income taxes payable 25 --
Capital lease obligations -- 94
-------- --------
TOTAL CURRENT LIABILITIES 5,488 4,684
Subordinated convertible debentures 2,500 2,500
-------- --------
TOTAL LIABILITIES 7,988 7,184
COMMITMENTS AND CONTINGENCIES (Note J)
SHAREHOLDERS' EQUITY (DEFICIT)
Preferred Stock, $.01 par value, authorized 2,000,000 shares,
issued and outstanding 15,000 -- --
Common Stock, $.01 par value, authorized 101,250,000
shares, issued and outstanding 16,660,285 167 167
Additional paid-in capital 15,803 15,802
Retained earnings (deficit) (16,034) (11,331)
-------- --------
TOTAL SHAREHOLDERS' EQUITY (DEFICIT) (64) 4,638
-------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) $ 7,924 $ 11,822
======== ========
Note: The September 28, 2002 consolidated balance sheet has been derived from
audited consolidated financial statements at that date included in the Company's
Annual Report on Form 10-K for the year ended September 28, 2002.
See notes to consolidated financial statements.
Page 4 of 21
PHOTOWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(in thousands, except per share and share data)
Third Quarter Ended Nine Months Ended
------------------------------- -------------------------------
June 28, June 29, June 28, June 29,
2003 2002 2003 2002
==============================================================================================================
Net revenues $ 6,987 $ 10,514 $ 21,840 $ 30,846
Cost of goods and services 4,939 7,657 16,894 23,582
------------ ------------ ------------ ------------
Gross profit 2,048 2,857 4,946 7,264
Operating expenses:
Marketing 543 1,779 1,955 3,659
Research and development 774 400 2,025 1,228
General and administrative 1,285 1,571 4,059 4,257
ITC penalty 1,600 -- 1,600 --
------------ ------------ ------------ ------------
Total operating expenses 4,202 3,750 9,639 9,144
------------ ------------ ------------ ------------
Loss from operations (2,154) (893) (4,693) (1,880)
Other income (expense):
Interest expense (43) (67) (129) (235)
Other income, net 17 35 37 106
------------ ------------ ------------ ------------
Total other expense, net (26) (32) (92) (129)
------------ ------------ ------------ ------------
Loss before income taxes (2,180) (925) (4,785) (2,009)
Income tax benefit (expense) (25) 484 82 4,242
------------ ------------ ------------ ------------
Net income (loss) $ (2,205) $ (441) $ (4,703) $ 2,233
============ ============ ============ ============
Earnings (loss) per share $ (.13) $ (.03) $ (.28) $ .13
============ ============ ============ ============
Earnings (loss) per share - diluted $ (.13) $ (.03) $ (.28) $ .13
============ ============ ============ ============
Weighted average shares 16,657,000 16,655,000 16,656,000 16,655,000
============ ============ ============ ============
Weight average shares and diluted
equivalents outstanding 16,657,000 16,655,000 16,656,000 17,060,000
============ ============ ============ ============
See notes to consolidated financial statements.
Page 5 of 21
PHOTOWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(in thousands)
Nine Months Ended
----------------------
June 28, June 29,
2003 2002
=========================================================================================
OPERATING ACTIVITIES:
Net income (loss) $(4,703) $ 2,233
Charges to income not affecting cash:
Depreciation and amortization 1,566 2,999
Deferred revenues 53 416
Accrued ITC penalty 1,600 --
Accrued lawsuit settlement -- (675)
Income taxes receivable/payable 1,726 (4,242)
Net change in receivables, inventories, payables and other 3,524 (152)
------- -------
NET CASH FROM OPERATING ACTIVITIES 3,766 579
INVESTING ACTIVITIES:
Purchase of furniture, fixtures, and equipment (263) (17)
Proceeds from sales of furniture, fixtures and equipment -- 66
------- -------
NET CASH FROM (USED IN) INVESTING ACTIVITIES (263) 49
FINANCING ACTIVITIES:
Payments on capital lease obligation (94) (151)
Payments on bank note payable -- (1,525)
Payment on note payable - other -- (38)
Proceeds from issuance of Common Stock 1 --
------- -------
NET CASH USED IN FINANCING ACTIVITIES (93) (1,714)
------- -------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 3,410 (1,086)
Cash and cash equivalents at beginning of period 1,175 2,861
------- -------
CASH AND CASH EQUIVALENTS
AT END OF PERIOD $ 4,585 $ 1,775
======= =======
Supplemental cash flow information
Cash paid for interest $ 89 $ 166
Cash received from income tax refund $ 1,808 --
See notes to consolidated financial statements.
Page 6 of 21
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, primarily through online and mail-order channels.
The PhotoWorks service provides digital printing services and film processing to
both traditional and digital camera users, primarily in the United States,
providing customers with the easiest way to store and organize photos online,
share them with friends and family, and order prints, reprints, photo albums,
and photo related products. The Company also offers an array of complementary
products and services, primarily under the PhotoWorks(R) brand name.
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 accounting principles generally accepted in the United
States for complete financial statements. In the opinion of management, all
adjustments (consisting of normal recurring adjustments) considered necessary
for a fair presentation of interim results have been included. The Company
follows a policy of recording its interim periods and year-end on a 13-week
basis for comparability of results and to be consistent with its internal weekly
reporting. Operating results for the nine-months ended June 28, 2003 are not
necessarily indicative of the results that may be expected for the fiscal year
ending September 27, 2003. 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 28, 2002 and the Company's consolidated
financial statements and footnotes thereto also included in the Company's Annual
Report.
NOTE B -- LIQUIDITY
The Company has experienced significant revenue declines and has incurred
operating losses in recent years. Cash flows from operations were positive in
the first nine months of fiscal 2003 and for the full fiscal year of 2002,
unlike the previous three fiscal years, primarily due to tax refunds received in
January 2003 and July 2002, for $1,808,000 and $3,865,000, respectively. The
Company has fully utilized its carryback potential for income taxes.
Working capital as of June 28, 2003 was $393,000 compared to $3,792,000 as
of September 28, 2002. Working capital was significantly impacted by an accrual
for $1,600,000 to record a penalty assessed by the ITC in May 2003 (see Note J).
If the Company is required to pay the $1,600,000 penalty, it will have a
material impact on the financial condition and liquidity of the Company.
While the Company has yet to return to profitability, management believes
that its current cash balances and its projected cash flows from operations will
be sufficient to fund operations in the near term.
NOTE C -- DEFERRED REVENUES
The Company defers revenue related primarily to a Frequent Customer
Program, which the Company began testing during the second quarter of fiscal
2002. Under this program, after processing a certain number of rolls of film
within a stated period of time, a customer receives free processing on their
next roll of film. For each roll of film for which the processing is paid under
this program, the Company defers a portion of the revenue received and
recognizes this upon processing of the free roll, so that revenue from customers
in this program is recognized ratably over all film rolls processed. Management
currently plans to discontinue this program by the end of the first quarter of
fiscal 2004.
Page 7 of 21
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE D -- INVENTORIES
Inventories are stated at the lower of cost (using the first-in, first-out
method) or market. Inventories consist primarily of film and photofinishing
supplies.
NOTE E -- SEGMENT REPORTING
The Company currently operates in one business segment.
NOTE F - RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform to the
current year's presentation.
NOTE G -- INCOME TAXES
Due to the uncertainty of the recoverability of net deferred tax assets of
$12,013,000, a valuation allowance for the same amount has been recorded. The
Company's net operating loss carryforwards are subject to limitations under
Internal Revenue Code (IRC) Section 382.
In March 2002, Congress enacted changes in the tax law that allowed the
Company to carryback additional tax losses that resulted in tax refunds of
$3,865,000, received in July 2002 and $1,808,000 received in January 2003.
During the second quarter of fiscal 2003, an adjustment was made to the 2002 AMT
calculation, resulting in an additional tax benefit of $107,000, which is
recorded as income tax receivable.
The Company recorded $25,000 in the third quarter of fiscal 2003 for
estimated income taxes payable as a result of alternative minimum tax
calculations for fiscal 2003.
NOTE H -- EARNINGS (LOSS) PER SHARE
Earnings per share is computed based on the weighted average number of
common shares and dilutive common stock equivalents outstanding during the
period. Convertible preferred shares, outstanding warrants and stock options to
purchase shares of common stock were excluded from the computations of loss per
share because their effect was antidilutive.
The following table sets forth the computation of basic and diluted
earnings (loss) per share:
Third Quarter Ended Nine Months Ended
-------------------------------- -------------------------------
June 28, 2003 June 29, 2002 June 28, 2003 June 29, 2002
==============================================================================================================================
Numerator for basic and diluted earnings per share:
Net income (loss) $ (2,205,000) $ (441,000) $ (4,703,000) $ 2,233,000
============ ============ ============ ===========
Denominator:
Denominator for basic earnings
per share - weighted-average shares 16,657,000 16,655,000 16,656,000 16,655,000
Net effect of dilutive stock options -- -- -- 405,000
------------ ------------ ------------ -----------
Denominator for diluted earnings per share 16,657,000 16,655,000 16,656,000 17,060,000
============ ============ ============ ===========
Basic earnings (loss) per share $ (.13) $ (.03) $ (.28) $ .13
============ ============ ============ ===========
Diluted earnings (loss) per share $ (.13) $ (.03) $ (.28) $ .13
============ ============ ============ ===========
Page 8 of 21
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE I -- STOCK-BASED COMPENSATION
Pursuant to Stock Option Plans adopted in 1982 and 1987, options may be
granted to purchase up to 6,904,688 shares of Common Stock at prices equal to
the fair market value of the shares at the time the options are granted.
On October 20, 1999 the Board of Directors adopted the PhotoWorks, Inc.
1999 Employee Stock Option Plan. Employees, consultants, independent
contractors, advisors and agents are eligible to participate in this plan.
Officers and directors are not eligible to participate. Pursuant to this plan,
options may be granted to purchase up to 800,000 shares of Common Stock at
prices equal to the fair market value of the shares at the time the options are
granted.
In February 2000, shareholders approved the 1999 Stock Incentive
Compensation Plan. Officers, directors, employees, consultants, independent
contractors, advisors and agents are eligible to participate in this plan.
Pursuant to this plan, options may be granted to purchase up to 1,800,000 shares
of Common Stock at prices equal to the fair market value of the shares at the
time the options are granted.
Shares of Common Stock reserved for issuance under these stock option
plans totaled 3,681,840 at June 28, 2003, of which 671,146 shares were available
for options to be granted in the future. Options generally vest over three to
four years and become exercisable commencing one year after the date of grant
and expiring five years after the date of grant.
The Company applies Accounting Principles Board Opinion (APB) No. 25 and
related interpretations in accounting for stock options.
Pro forma information regarding net income (loss) and earnings (loss) per
share has been determined as if the Company had accounted for its employee stock
options under the fair value method of SFAS No. 123. The fair value for the
options was estimated at the date of grant using a Black-Scholes option pricing
model with the following weighted-average assumptions on the option grant date:
June 28, 2003 June 29, 2002
================================================================================
Risk free interest rate 1.51% 3.49%
Expected volatility 147.59% 134.82%
Expected option life 3.13 years 2.79 years
Dividend yield 0.00% 0.00%
Under Statement No. 123, if the Company had elected to recognize the
compensation cost based upon the fair value of the options granted at grant
date, net income would have been reduced as follows:
Third Quarter Ended Nine Months Ended
-------------------------------------- --------------------------------
June 28, 2003 June 29, 2002 June 28, 2003 June 29, 2002
==========================================================================
Net income (loss) as reported $ (2,205,000) $ (441,000) $ (4,703,000) $ 2,233,000
Add: Stock-based compensation expense
included in net income, net of related tax effects -- -- -- --
Deduct: Stock-based compensation as determined
under FAS 123, net of related tax effects (89,000) (90,000) (357,000) (424,000)
------------- ------------- ------------- -------------
Pro forma net income (loss) $ (2,294,000) $ (531,000) $ (5,060,000) $ 1,809,000
============= ============= ============= =============
Basic earnings (loss) per share as reported $ (.13) $ (.03) $ (.28) $ .13
============= ============= ============= =============
Diluted earnings (loss) per share as reported $ (.13) $ (.03) $ (.28) $ .13
============= ============= ============= =============
Pro forma basic earnings (loss) per share $ (.14) $ (.03) $ (.30) $ .11
============= ============= ============= =============
Pro forma diluted earnings (loss) per share $ (.14) $ (.03) $ (.30) $ .11
============= ============= ============= =============
Page 9 of 21
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE J -- CONTINGENCIES
Fuji Photo Film Co., Ltd - The Company was a defendant in a claim filed by
Fuji Photo Film Co., Ltd. with the International Trade Commission. Fuji alleged
that a number of companies, including the Company's OptiColor subsidiary,
violated patents held by Fuji on single-use cameras by bringing recycled
single-use cameras into the United States for resale. 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
appealed the ITC Commissioners' order to the Federal Circuit Court of Appeals
and that Court issued a decision in November 2001, upholding the order against
the Company.
In July 2001, the ITC commenced enforcement and advisory opinion
proceedings against the Company and several other respondents, based on a
complaint filed by Fuji with the ITC. This complaint alleged that the Company
infringed certain claims of six of Fuji's patents on single use cameras, through
the importation and sale of certain newly manufactured reloadable cameras. The
complaint requested that the ITC determine that, through these imports and
sales, the Company violated the ITC's previous order. It also requested that the
ITC bring an action in an appropriate U.S. District Court to seek an injunction
and civil penalties for each day in which an importation or sale violating the
order occurred in an amount up to the maximum provided by the governing statute.
In May 2002, an Administrative Law Judge of the International Trade Commission
issued an initial determination that the Company's reloadable camera infringes
three patents owned by Fuji Photo Film Co., Ltd for single-use cameras and
recommended that the Commission assess a penalty of $1.6 million for such
infringement.
The Commission upheld the infringement determination and, in May 2003,
upheld the penalty assessment of $1,600,000. As such, the Company accrued the
$1,600,000 penalty assessment in the third quarter of fiscal 2003. This action
by the International Trade Commission has been appealed to the Federal District
Court of Appeals. The Company believes it has strong arguments regarding the
infringement determination and penalty assessment and intends to pursue such
challenges to the extent it deems appropriate. If the Company is required to pay
the penalty amount, it would have a significantly negative impact on the
financial condition and liquidity of the Company.
Washington Department of Revenue - The Company has an outstanding tax
issue with the Washington State Department of Revenue related to use taxes owed
as a result of advertising materials, including order forms, mailed to
out-of-state customers. The Company is seeking resolution of the issues
involved, primarily related to future periods, as this is an ongoing issue for
the Company for tax reporting periods after January 1, 1998. That is, it is
reasonable that a future routine audit by the Department of Revenue will result
in a further use tax assessment unless the issue can be resolved in a manner
favorable to the Company prior to such audit assessment. The Company believes
its accrual of approximately $150,000 is adequate for possible assessments
related to the outstanding issue.
Massachusetts Institute of Technology - On April 25, 2002, a Complaint was
filed against the Company and over 200 other defendants by The Massachusetts
Institute of Technology and Electronics for Imaging, Inc. claiming infringement
on a patent issued in 1985 for a Color Reproduction System. The Complaint
requests injunctive relief, damages adequate to compensate them for Defendants'
infringement of the 4,500,919 patent, their costs and prejudgment interest on
their damages and reasonable attorney fees.
In July 2003, without admitting wrongdoing or liability, and for the sole
purpose of settling disputed claims and avoiding costs and risks of further
litigation, PhotoWorks and Electronics for Imaging agreed to a settlement amount
of $90,000, payable in two payments of $45,000. The full settlement amount was
recorded as an expense in the third quarter of fiscal 2003. The first payment is
due in August 2003 and the second payment is due in August 2004.
Page 10 of 21
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE J -- CONTINGENCIES (Continued)
Sharon Drinkard, et al vs. PhotoWorks, Inc. - A complaint was filed in
March 2000, alleging 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". 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 represented the Class, agreed to a settlement which was
approved by the Court in July 2001. In fiscal 2001, the Company accrued a total
of $675,000 related to the future distribution of 900,000 rolls of film pursuant
to the terms of the final settlement. As of September 28, 2002, the Company had
distributed approximately $675,000 of film, thus fully discharging its liability
under the settlement.
Although the Company believes it has a reasonable position relative to the
unresolved claims listed above, it is not possible to predict an outcome at this
time or the potential affect on its business or financial condition. The
Company's defense of these claims will cause it to incur additional legal
expenses.
The Company is also involved in various routine legal proceedings in the
ordinary course of its business.
Page 11 of 21
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
Company 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 ability to generate cash to fund operating
activities or obtain additional funding, effective execution of product launches
or marketing programs, pricing and other activities by competitors, economic and
industry factors, system performance problems due to technical difficulties, and
other risks, including those described in the Company's Annual Report on Form
10-K and those described 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 photo
services company dedicated to providing its customers with innovative ways to
enjoy and use their photos. PhotoWorks is committed to helping digital
photographers capture, manage, store, and share their images and enjoy
professional-quality prints. The Company offers an array of complementary
services and products, primarily under the PhotoWorks(R) brand name.
The net loss for the first nine months of fiscal 2003 was $4,703,000, or a
loss of $.28 per share, compared to net income of $2,233,000, or earnings of
$.13 per share for the first nine months of fiscal 2002. The fiscal 2003 results
include a non-cash charge in the third quarter of $1,600,000 as the result of a
penalty assessment issued by the International Trade Commission in May 2003 (see
Note J in Notes to Consolidated Financial Statements). The prior year results
included tax benefits of $4,242,000 related to refunds received for tax years
2001 and 2002, pursuant to the "Job Creation and Worker Assistance Act."
Operating results may fluctuate in the future due to changes in the mix of
sales, marketing and promotional activities, introductions of new products,
research and development requirements, actions by competitors, price increases
by suppliers, conditions in the direct-to-consumer market and the photofinishing
industry in general, national and global economic and political conditions, and
other factors.
Demand for the Company's services and products is generally seasonal.
However, seasonality of demand may be offset by changes in the effectiveness of
marketing programs, the introduction of new services and products, actions by
competitors and other factors. Operating results are 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 product
development and marketing expenditures.
Critical Accounting Policies
Management's Discussion and Analysis of Financial Condition and Results of
Operations discusses the Company's consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires management
to make estimates and judgments that affect the reported amounts of assets,
liabilities, net revenue, and expenses. Management's estimates and judgments are
based upon the Company's historical experience, knowledge of economic and market
factors, and various other factors that are believed to be relevant given the
circumstances. Significant policies, methodologies, estimates, and the factors
used therein, are reviewed on at least a quarterly basis with the Company's
Audit Committee. Actual results may differ from these estimates.
Page 12 of 21
The following is a discussion of the estimates included in the Company's
financial statements that encompass matters of uncertainty, whereby different
estimates could have reasonably been made or changes in such estimates could
have a material impact on the financial statements of the Company.
Allowance for Doubtful Accounts
The allowance for doubtful accounts is based on the Company's historical
loss percentage for bad debts as a percentage of sales with consideration given
to the aging of the receivables. Additionally, we review customers with large
past due balances on at least a monthly basis. Based on our assessment of the
financial condition of such customers, past payment history, and other
circumstances, we record a specific allowance for those accounts that we
determine may be uncollectible. We are unable to predict changes in the
financial condition of our customers, or general economic conditions.
Accordingly, if circumstances related to either of these change, our estimate of
an appropriate allowance for doubtful accounts could be materially affected and
we may be required to record additional allowances.
Reserve for Obsolete Inventory
Management regularly assesses the valuation of the Company's inventory and
writes down those inventories that are obsolete, or in excess of forecasted
usage, to their estimated realizable value. A reserve for obsolescence is
recorded against inventory for any film or paper inventories that are nearing
their expiration dates. Additional reserves are recorded for slow-moving or
discontinued stock to the extent it is estimated the materials may go unused
based on historical inventory turnover, planned changes in marketing promotions
or other anticipated changes in product mix over the next year, seasonality, or
other factors. Estimates of future usage are based on estimates of future sales
and product mix. If actual sales or product mix differs from management's
estimates, the Company may need to record additional reserves for obsolete
inventory.
Deferred Revenues
The Company's deferred revenues relate primarily to a Frequent Customer
Program, which the Company began testing during the second quarter of fiscal
2002. Under this program, after processing a certain number of rolls of film
within a stated period of time, a customer receives free processing on their
next roll of film. For each roll of film for which the processing is paid under
this program, the Company defers a portion of the revenue received and
recognizes the revenue upon processing of the free roll, so that revenue from
customers in this program is recognized ratably over all film rolls processed.
Management believes it is unlikely that all customers in this program will
process the requisite number of rolls that entitle them to the free processing.
However, because there was not historical data on which to estimate a percentage
of customers that would not achieve this benefit the Company was deferring the
maximum amount of revenue. During the third quarter of fiscal 2003, management
believed it had obtained adequate information on certain customer segments to
begin reducing the percentage of revenue deferred for these groups. As this
program nears its expiration in December 2004 and more information is obtained,
management will likely reduce this percentage within a reasonable range and
reduce its deferral of revenues under this program accordingly. Such a reduction
may have a material impact on the reported revenues of the Company in the period
the reduction is recognized.
Deferred Tax Assets
The Company has net deferred tax assets totaling $12,013,000, comprised
primarily of net operating loss carryforwards. Due to its recent history of
operating losses, the uncertainty of future profits, and limitations on the
utilization of net operating loss carryforwards under IRC Section 382,
management has recorded a valuation allowance of $12,013,000 against its net
deferred tax assets.
Contingencies
The Company is subject to various legal proceedings and claims (see Part
II, Item 1 - Legal Proceedings), the outcomes of which are subject to
significant uncertainty. SFAS 5, Accounting for Contingencies, requires that an
estimated loss from a contingency should be recorded if it is probable that a
liability has been incurred and the amount of the loss can be reasonably
estimated. Disclosure of a contingency is required if there is at least a
reasonable possibility that a loss may have been incurred. The Company
evaluates, among other factors, the degree of probability of an unfavorable
outcome and the ability to make a reasonable estimate of the amount of loss.
Page 13 of 21
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.
Third Quarter Ended Nine Months Ended
--------------------- ---------------------
June 28, June 29, June 28, June 29,
2003 2002 2003 2002
- -===============================================================================
Net revenues 100.0% 100.0% 100.0% 100.0%
Cost of goods and services 70.7 72.8 77.4 76.5
----- ----- ----- -----
Gross profit 29.3 27.2 22.6 23.5
Operating expenses:
Marketing 7.7 16.9 8.9 11.8
Research and development 11.1 3.8 9.3 4.0
General and administrative 18.4 15.0 18.6 13.8
ITC penalty 22.9 -- 7.3 --
----- ----- ----- -----
Total operating expenses 60.1 35.7 44.1 29.6
----- ----- ----- -----
Loss from operations (30.8) (8.5) (21.5) (6.1)
Total other expense (.4) (.3) (.4) (.4)
----- ----- ----- -----
Loss before income taxes (31.2) (8.8) (21.9) (6.5)
Income tax benefit (expense) (.4) 4.6 .4 13.7
----- ----- ----- -----
Net income (loss) (31.6)% (4.2)% (21.5)% 7.2%
===== ===== ===== =====
Net revenues for the third quarter of fiscal 2003 were $6,987,000,
compared to net revenues of $10,514,000 in the third quarter of fiscal 2002. For
the nine months ended June 28, 2003, net revenues were $21,840,000 compared to
$30,846,000 for the same period of fiscal 2002. The decline in net revenues was
primarily due to lower film processing volumes and it is expected that this
trend will continue. Management believes that travel and leisure activities were
affected by events surrounding the war in Iraq and thereby contributed to a
reduction in overall film processing volumes. In addition, the transition from
film to digital cameras has been a factor in the declining film processing
volumes for the photofinishing industry. The lower film processing volumes were
slightly offset by increases in net revenues from digital printing services. In
the third quarter of fiscal 2003, net revenues from digital printing services
increased to approximately $586,000, or 8.4% of net revenues, compared to
$247,000 or 2.3% of net revenues in the third quarter of fiscal 2002. For the
first nine months of fiscal 2003, net revenues from digital printing services
were $1,946,000 or 8.9% of net revenues, compared to $951,000 or 3.1% of net
revenues in the prior year. In addition, net revenues for the third quarter of
the prior year included approximately $643,000 from sales of the Company's
preloaded cameras. There were no sales of preloaded cameras in the current
fiscal year. Net revenues in the third quarter of fiscal 2002 also include
approximately $218,000 from retail locations that were closed during the last
twelve months. Over the past two years, the Company has closed a majority of its
retail stores and plans to close its remaining eight retail store locations by
the end of September 2003. The costs associated with store closures are not
expected to be material to the operating results of the Company.
Cost of goods and services consists of labor, processing materials and
supplies, shipping and handling costs and fixed operating costs related to the
Company's services and products. Gross profit in the third quarter of fiscal
2003 increased to 29.3% compared to 27.2% of net revenues in the third quarter
of fiscal 2002. The increase was due primarily to lower labor and material costs
from efficiencies in digital printing plus lower customer service and other
overhead costs due to cost savings initiatives. In addition, margin on certain
digital print services increased due to higher selling prices in the third
quarter of fiscal 2003. Prior to the third quarter, the Company was marketing an
introductory $.19 print offer for 4 x 6 digital prints. The Company currently
offers 4 x 6 digital prints at a price of $.29. For the first nine months of
fiscal 2003, gross profit decreased to 22.6% compared to 23.5% for the same
period of fiscal 2002. The decrease in gross margin year-to-date was primarily
due to lower revenues (in absolute dollars) and lower margins on certain digital
print services, primarily the Company's $.19 digital print price promotion which
was effective through March 31, 2003. Gross profit fluctuates due to the
seasonality of processing volumes and revenues against fixed production costs
associated with equipment, facilities and other overhead costs related to
services and products.
Page 14 of 21
Total operating expenses in the third quarter of fiscal 2003 increased to
$4,202,000 compared to $3,750,000 in the third quarter of fiscal 2002. For the
first nine months of fiscal 2003, total operating expenses increased to
$9,639,000 compared to $9,144,000 for the same period of fiscal 2002. The
increase in operating expenses in the third quarter was primarily due to a
$1,600,000 penalty assessment by the ITC that was recorded in the third quarter
of fiscal 2003 (see Note J in Notes to Consolidated Financial Statements).
Exclusive of the ITC penalty, operating costs in the third quarter decreased
compared to the prior year to $2,602,000. The fiscal 2003 periods reflect a
reduction in marketing and general and administrative expenses, partially offset
by increased expenditures for research and development related to new digital
services and products. Future operating costs may fluctuate due to the timing
and magnitude of research and development, marketing and other activities.
Marketing expenses in the third quarter of fiscal 2003 decreased to
$543,000 compared to $1,779,000 in the third quarter of fiscal 2002. For the
first nine months of fiscal 2003, marketing expenses decreased to $1,955,000
compared to $3,659,000 for the same period in fiscal 2002. Marketing
expenditures in fiscal 2003 were lower primarily due to the Company's focus on
its existing customers through targeted retention and reactivation programs. The
Company continues to test and evaluate new marketing programs and generate
awareness through public relations efforts to effectively acquire new customers
and promote the Company's digital products and services. Marketing expenditures
for fiscal 2003 are expected to be lower as compared to fiscal 2002.
Research and development expenses increased to $774,000 for the third
quarter of fiscal 2003 compared to $400,000 in the third quarter of fiscal 2002.
For the first nine months of fiscal 2003, research and development costs
increased to $2,025,000 as compared to $1,228,000 for the same period of fiscal
2002. The increase was due primarily to investments in new digital related
services. Research and development expenses consist primarily of costs incurred
in developing solutions for digital print services, online photo archiving and
sharing services, image management and creating equipment necessary to provide
customers with new digital photographic services and products. Current projects
focus on digital-related products that management believes offer digital camera
users with solutions to their digital imaging needs and products that offer
film-based customers the convenience of digital services.
General and administrative expenses decreased to $1,285,000 for the third
quarter of fiscal 2003 compared to $1,571,000 for the third quarter of fiscal
2002. For the nine months ended June 28, 2003, general and administrative
expenses decreased to $4,059,000 compared to $4,257,000 for the same period of
fiscal 2002. General and administrative expenses consist of costs related to
management information systems, computer operations, human resource functions,
finance, legal, accounting, investor relations and general corporate activities.
In March 2002, Congress enacted changes in the tax law that allowed the
Company to carryback additional tax losses that resulted in tax refunds of
$3,865,000, received in July 2002 and $1,808,000 received in January 2003. In
fiscal 2003, an adjustment was made to the 2002 AMT calculation, resulting in an
additional tax benefit of $107,000, which is recorded as income tax receivable.
Income tax expense of $25,000 reflects estimated amounts due as a result of
alternative minimum tax calculations for the current fiscal year.
Liquidity and Capital Resources
As of August 1, 2003, the Company's principal source of liquidity included
approximately $4,577,000 in cash and cash equivalents. In addition, during the
first nine months of fiscal 2003, the Company generated cash from operating
activities of $3,766,000 compared to $579,000 in the first nine months of fiscal
2002. The increase was primarily due to a tax refund received in January 2003 of
$1,808,000 and certain expenditures made in September 2002 of $3,455,000,
primarily for prepayment of postage and other shipping costs and maintenance
contracts, which are being utilized in fiscal 2003. As of June 28, 2003,
approximately $68,000 of the prepaid expenditures remain.
The Company currently anticipates that existing cash and cash equivalents
and projected future cash flows from operations will be sufficient to fund its
operations, including any capital expenditures, through at least the next twelve
months. However, if the Company does not generate sufficient cash from
operations to satisfy its ongoing expenses, the Company may be required to seek
external sources of financing or refinance its obligations. Possible sources of
financing include the sale of equity securities or bank borrowings. There can be
no assurance that the Company will be able to obtain adequate financing in the
future.
Page 15 of 21
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 legal proceeding filed by Massachusetts
Institute of Technology/Electronics for Imaging on April 25, 2002, see Note J of
Notes to Consolidated Financial Statements in Part I above.
ITEM 5 - CONTROLS AND PROCEDURES
At the end of the period covered by this report, as part of our quarterly
review, we evaluated, under the supervision and with the participation of the
Company's management, including our Chief Executive Officer and Chief Accounting
Officer, the effectiveness of the design and operation of our disclosure
controls and procedures pursuant to Exchange Act Rule 13a-14 and 15d-14. Based
upon that evaluation, the Chief Executive Officer and the Chief Accounting
Officer concluded that our disclosure controls and procedures are effective to
timely alert them to any material information relating to the Company (including
its consolidated subsidiaries) that must be included in our periodic SEC
filings. There have been no significant changes in the Company's internal
controls or in other factors that could significantly affect internal controls
subsequent to their evaluation.
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
10.1 Employment and Severance and Release for Gary R.
Christophersen
31 Certification Pursuant to Rule 13a-14 of the Securities
Exchange Act of 1934 as Adopted Pursuant to Section 302 of the
Sarbannes-Oxley Act of 2002
32 Certification of Principal Executive Officers pursuant to 18
U.S.C Section 1350, as Adopted Pursuant to Section 906 of the
Sarbannes-Oxley Act of 2002
(b) Reports on Form 8-K.
Form 8-K dated May 22, 2003 - Item 5 - Other Events related to the
International Trade Commission penalty of $1.6 million against the
Company.
Page 16 of 21
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: August 11, 2003 /s/ Gary R. Christophersen
------------------------------------
Gary R. Christophersen
Chief Executive Officer and Chairman
(Principal Executive Officer)
/s/ Loran Cashmore Bond
------------------------------------
Loran Cashmore Bond
Vice President Administration
Treasurer/Chief Accounting Officer
Page 17 of 21
INDEX TO EXHIBITS
PHOTOWORKS, INC.
Quarterly Report on Form 10-Q
For The Quarter Ended June 28, 2003
Exhibit Description Page No.
- ------- ----------- --------
3.1 Third Amended and Restated Articles of Incorporation dated January
27, 1998. (Incorporated by reference to Form 10-K/A for the year
ended September 25, 1999, filed January 14, 2000.)
3.2 Articles of Amendment to Articles of Incorporation dated January 25,
2000. (Incorporated by reference from Form 10-Q for the quarter
ended December 25, 1999.)
3.3 Articles of Amendment to Articles of Incorporation of PhotoWorks,
Inc. dated February 9, 2000 (Incorporated by reference to Exhibit
3.1 filed with the Company's 8-K filed February 16, 2000)
3.4 Articles of Amendment to Articles of Incorporation of PhotoWorks,
Inc. dated April 24, 2001 (Incorporated by reference to Exhibit 3.1
filed with the Company's 8-K filed April 27, 2001)
3.5 Articles of Correction to Articles of Incorporation of PhotoWorks,
Inc. dated April 25, 2001 (Incorporated by reference to Exhibit 3.2
filed with the Company's 8-K filed April 27, 2001)
3.6 Form of Certificate of Designation Preferences and Rights of Series
RP Preferred Stock (Incorporated by reference to Exhibit 3.4 to the
Company's Annual Report on 10-K for the year ended September 25,
1999)
3.7 Bylaws of the Company, as amended and restated on November 13, 1996.
(Incorporated by reference to Exhibit 3.2 filed with the Company's
Annual Report on Form 10-K for the year ended September 28, 1996)
4.1 Rights Agreement dated December 16, 1999 between the Registrant and
Chase Mellon Shareholder Services L.L.C., as Rights Agent
(Incorporated by reference to Exhibit 4.1 to the current report on
Form 8-K filed with the Commission on December 17, 1999)
10.1 Employment and Severance Agreement and Release with Gary R. SEC Electronic
Christophersen dated June 13, 2003 Filing
31 Certification Pursuant to Rule 13a-14 of the Securities Exchange Act
of 1934 as Adopted Pursuant to Section 302 of the Sarbannes-Oxley
Act of 2002 19-20
32 Certification of Principal Executive Officers Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of the
Sarbannes-Oxley Act of 2002 21
Page 18 of 21