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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
(Mark One)
[x] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934.
For the fiscal year ended January 31, 2005 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 1-13437
SOURCE INTERLINK COMPANIES, INC.
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 20-2428299
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
27500 RIVERVIEW CENTER BLVD., SUITE 400
BONITA SPRINGS, FLORIDA 34134
(Address of Principal Executive Offices) (Zip Code)
(239) 949-4450
(Registrant's Telephone Number, Including Area Code)
Securities to be registered pursuant to Section 12(b) of the Act: NONE
Securities to be registered pursuant to Section 12(g) of the Act:
COMMON STOCK $0.01 PAR VALUE
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
Yes [X] No [ ]
The aggregate market value of the voting and non-voting common equity held by
non-affiliates of the registrant as of April 13, 2005 was approximately $297.6
million computed by reference to the price at which the common equity was sold
on July 31, 2004, the last day of the registrant's most recently completed
second fiscal quarter, as reported by The Nasdaq National Market
At April 13, 2005, the Company had 51,007,714 shares of common stock
outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the Source Interlink Companies, Inc. Annual
Meeting of Stockholders to be held on July 12, 2005 are incorporated by
reference into Part III of this Annual Report to the extent described in Part
III hereof.
TABLE OF CONTENTS
Page
----
PART I
ITEM 1. Business 2
ITEM 2. Properties 18
ITEM 3. Legal Proceedings 19
ITEM 4. Submission of Matters to a Vote of Security Holders 19
PART II
ITEM 5. Market for Registrant's Common Equity, Related Stockholder Matters 20
and Issuer Purchases of Equity Securities
ITEM 6. Selected Financial Data 20
ITEM 7. Management's Discussion and Analysis of Financial Condition 22
and Results of Operations
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk 40
ITEM 8. Financial Statements and Supplementary Data 41
ITEM 9. Changes In and Disagreements with Accountants on 41
Accounting and Financial Disclosure
ITEM 9A. Controls and Procedures 41
ITEM 9B. Other Information 43
PART III
ITEM 10. Directors and Executive Officers of the Registrant 43
ITEM 11. Executive Compensation 43
ITEM 12. Security Ownership of Certain Beneficial Owners and Management 43
And Related Stockholder Matters
ITEM 13. Certain Relationships and Related Transactions 43
ITEM 14. Principal Accountant Fees and Services 43
PART IV
ITEM 15. Exhibits and Financial Statement Schedules 44
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Some of the information contained in this Annual Report on Form 10-K
including, but not limited to, those contained in Item 1. "Business" and Item 7
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," along with statements in other reports filed with the Securities
and Exchange Commission (the "SEC"), external documents and oral presentations,
which are not historical facts are considered to be "forward-looking statements"
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. The words
"believe," "expect," "anticipate,' "estimate," "project," and similar
expressions often characterize forward-looking statements. These statements may
include, but are not limited to, projections of collections, revenues, income or
loss, cash flow, estimates of capital expenditures, plans for future operations,
products or services, and financing needs or plans, as well as assumptions
relating to these matters. These statements are only predictions and you should
not unduly rely on them. Our actual results will differ, perhaps materially,
from those anticipated in these forward-looking statements as a result of a
number of factors, including the risks and uncertainties faced by us described
below and those set forth below under the heading "Risk Factors that Might
Affect Future Operating Results and Financial Condition":
- market acceptance of and continuing demand for magazines, DVDs, CDs and
other home entertainment products;
- the impact of competitive products and technologies;
- the pricing and payment policies of magazine publishers, film studios,
record labels and other key vendors;
- our ability to obtain additional financing to support our operations;
- changing market conditions and opportunities;
- our ability to realize operating efficiencies, cost savings and other
benefits from recent and pending acquisitions; and,
- retention of key management and employees.
We believe it is important to communicate our expectations to our
investors. However, there may be events in the future that we are not able to
predict accurately or over which we have no control. The factors listed above
provide examples of risks, uncertainties and events that may cause our actual
results to differ materially from the expectations we describe in our
forward-looking statements. Before you make an investment decision relating to
our common stock, you should be aware that the occurrence of the events
described in these risk factors and those set forth below under ITEM 1 --
"Business--Risk Factors that Might Affect Future Operating Results and Financial
Condition" could have a material adverse effect on our business, operating
results and financial condition. You should read and interpret any
forward-looking statement in conjunction with our consolidated financial
statements, the notes to our consolidated financial statements and "ITEM
7--Management's Discussion and Analysis of Financial Condition and Results of
Operations." Any forward-looking statement speaks only as of the date on which
that statement is made. Unless required by U.S. federal securities laws, we will
not update any forward-looking statement to reflect events or circumstances that
occur after the date on which the statement is made.
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PART I
ITEM 1. BUSINESS.
OVERVIEW
On February 28, 2005, we completed our merger with Alliance Entertainment
Corp: a logistics and supply chain management services company for the home
entertainment product market, principally selling CDs and DVDs. Following the
merger, we organized the combined company into two operating business units:
Supply Chain Management and In Store Services. For a discussion of Alliance and
the merger, see "Recent Developments" discussed below. The discussion of our
business includes the operations of the post-merger combined company.
In conjunction with the merger, the company is re-assessing its business
segments. These segments will be included in one of two principal business
units, In-Store Services and Supply Chain Management.
We provide supply chain management and/or related value-added products and
services to most national regional retailers, magazine publishers and other
providers of home entertainment content.
Our clients include:
- Mainstream retailers, such as The Kroger Company, Target Corporation,
Walgreen Company, Ahold USA, Inc., Kmart Corporation, Sear Roebuck &
Co., and Meijers;
- Specialty retailers, such as Barnes & Noble, Inc., Borders Group, Inc.,
The Musicland Group, Inc., Hastings Entertainment, Inc., Fry's
Electronics, Inc. and Circuit City Stores, Inc.;
- e-commerce retailers, such as amazon.com, barnesandnoble.com,
circuitcity.com and bestbuy.com;
Our suppliers include:
- Record labels, such as Vivendi Universal S.A., Sony BMG Music
Entertainment Company, WEA Distribution and Thorn-EMI;
- Film studios, such as The Walt Disney Company, Time-Warner Inc., Sony
Corp., The News Corporation, Viacom Inc. and General Electric Company;
and,
- Magazine Distributors, such as COMAG Marketing Group, LLC., Time Warner
Retail Sales & Marketing, Inc., Curtis circulation Company and Kable
Distribution Services, Inc.;
Our business model is designed to deliver a complete array of products and
value-added services developed to assist retailers and manufacturers of digital
versatile disks (DVDs), audio compact disks (CDs), magazines, confections and
general merchandise in efficiently and effectively marketing their products to
consumers visiting the more than 110,000 store fronts we serve.
CORPORATE GOVERNANCE
Copies of our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q,
Current Reports on Form 8-K and all amendments to those reports are available,
as soon as practicable after filing with the SEC, free of charge on our website,
www.sourceinterlink.com. Our Code of Business Conduct and Ethics is also
available on our website, together with the charters for the Audit Committee,
Compensation Committee, Nominating and Corporate Governance Committee and
Capital Markets Committee of our Board of Directors. Written requests for copies
of these documents may be directed to Investor Relations at our principal
executive offices.
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INDUSTRY OVERVIEW
HOME ENTERTAINMENT CONTENT
According to industry sources, including the Motion Picture Association,
the Recording Industry Association of America, and Harrington Associates, LLC,
the total retail market in calendar year 2003 for DVDs, prerecorded music and
single-copy magazines was approximately $37.1 billion. Retail sales of DVDs
increased nearly 50% between 2002 and 2003.
The structure of the distribution channel for single-copy magazines has
changed little over the past several decades. Publishers each generally engage a
single national distributor, which acts as its representative to regional and
local wholesalers and furnishes billing, collecting and marketing services
throughout the United States or other territories. These national distributors
then secure distribution to retailers directly, or more typically, through a
number of regional and local wholesalers. The wholesalers maintain direct vendor
relationships with the retailers. Retailers in the mainstream retail market
require these wholesalers to provide extensive in-store services including
receiving, verifying, stocking new issues and removing out-of-date issues.
However, this traditional structure is not economically viable in the specialty
retail market. Thus, wholesalers servicing the specialty retail market typically
do not provide these in-store services.
In contrast, the distribution channel for prerecorded video and music
products is dominated by the major film studios and record labels, which
through their respective distribution units increasingly compete with
intermediaries by seeking to establish direct trading relationships with high
volume retailers. This disintermediation strategy has limited appeal to
retailers that demand a variety of value-added services, including e-commerce
support, inventory management, return logistics, advertising and marketing
assistance, information services, and in store merchandising services. Some
retailers have sought to maintain a duel supply chain by establishing a direct
trading relationship with the major studios and labels for high volume product,
primarily newly released titles, and a more expansive procurement and service
relationship with intermediaries to secure lower volume, higher margin product
and value-added services.
IN-STORE SERVICES
Front-End Management
The retail sale of single-copy magazines is largely an impulse purchase
decision by the consumer, and the retail sale of other home entertainment
content is becoming increasingly so. As a result, film studios, record labels,
publishers and manufacturers of other impulse merchandise such as confections
and general merchandise (i.e., razor blades, film, batteries, etc.) consider it
important for their products to be on prominent display in those areas of a
store where they will be seen by the largest number of shoppers in order to
increase the likelihood that their products will be sold. Retailers typically
display DVDs, CDs, magazines, confections and general merchandise in specific
aisles, or the "mainline," and the checkout area, or the "front-end." Product
visibility is highest in the front-end because every shopper making a purchase
must pass through this area.
Due to the higher visibility and resulting perception of increased sales
potential, vendors compete vigorously for favorable display space in the
front-end. To secure the desired display space, vendors offer rebate and other
incentive payments to retailers, such as:
- initial fees to rearrange front-end display fixtures to ensure the desired
placement of their products;
- periodic placement fees based on the location and size of their products'
display; and
- cash rebates based on the total sales volume of their products.
Due to the high volume of sales transactions and great variety of
incentive programs offered, there is a significant administrative burden
associated with front-end management. As a result, most retailers have
historically outsourced the information gathering and administration of rebate
claims collection to third parties such as our
3
company. This relieves retailers of the administrative burdens, such as
monitoring thousands of titles each with a distinct incentive arrangement.
Information Services
Prompt delivery of information regarding sales activity, including timing
of the redesign of front-end space, changes in display positions or the
discontinuance of a vendor's product, is important to vendors of front-end
products. This information allows vendors to make important strategic decisions
in advance of re-configurations and other changes implemented by retailers to
the front-end. Conversely, timely delivery of information about price changes,
special promotions, new product introductions and other plans is important to
retailers because it enables them to enhance the revenue potential of the
front-end. Historically, information available to vendors regarding retail
activity at the front-end and information available to retailers about vendors
has been fragmented and out-of-date. We believe that there is an increasing
demand on the part of vendors of front-end products for more frequent and
detailed information regarding front-end retail activity. Through our operating
units we have access to a significant amount of information regarding retail
front-end and mainline sales activity.
OUR BUSINESS
Our business consists of two strategic business units:
- Our Supply Chain Management unit distributes DVDs, CDs, domestic and
foreign titled magazines, confections and general merchandise to specialty
and mainstream retailers, renders fulfillment services for DVDs and CDs
sold by eCommerce retailers and provides a comprehensive category
management solution to its clients' home entertainment department. This
unit also exports domestic titled magazines from more than 100 publishers
to foreign markets worldwide.
- Our In-Store Services unit assists its clients with the design and
implementation of display fixture programs, collects rebate and other
incentive payments and provides access to real-time sales information
enabling its clients to make more informed decisions regarding their
product placement and marketing strategies.
SUPPLY CHAIN MANAGEMENT
In the spring of 2001, we acquired a group of affiliated specialty magazine
distributors to establish a platform from which to offer an expanding list of
merchandise and services to retailers. From 2002 through 2004, we continued to
expand our magazine product offerings by licensing and then purchasing
international distribution rights to a series of domestic magazine titles. In
February 2005, we further expanded our product offering beyond magazine
fulfillment to include DVDs, CDs and other home entertainment content products
through our merger with Alliance. On March 18, 2005, we signed a letter of
intent to acquire Chas. Levy Circulating Co., one of the principal magazine
wholesalers in the United States, for the purpose of strengthening our position
in the mainstream market. For a more complete discussion of the Alliance merger
and the proposed acquisition of Chas. Levy Circulating Co., see "Recent
Developments."
Currently, our Supply Chain Management unit offers a broad array of products
and services including the following:
Product Procurement. Through our extensive relationships with record
labels, film studios, magazine publishers and other producers of home
entertainment content, we can offer our retail clients the ability to display
virtually every domestic DVD, CD and magazine title and a significant selection
of foreign titled magazines. To maintain the high order fill rate demanded by
our clients, we have established an in stock catalogue of approximately 300,000
CD titles and approximately 100,000 DVD titles. We purchase home entertainment
content from every major record label, film studio and magazine publisher,
typically on a fully returnable basis.
Product is received at strategically located distribution centers. The
principal distribution centers are located in Harrisburg, Pennsylvania, Coral
Springs, Florida, Shepherdsville, Kentucky, Dallas, Texas and Carson City,
Nevada. At each of these distribution points, we process merchandise orders
using sophisticated warehouse
4
management systems. Once filled, orders are shipped to our retailers by a
combination of third party freight carriers and, in certain high volume
locations, in-house truck delivery. Given our broad distribution infrastructure,
we are capable of delivering home entertainment content overnight to virtually
any location within the continental United States.
Fulfillment Services. Our sophisticated warehouse management systems,
just-in-time replenishment and order regulation techniques enable us to offer
value-added fulfillment services including next day order delivery, ready for
shelf inventory preparation (such as price labeling and security device
placement) and a wide variety of electronic data interchange tools.
Most customers utilizing our fulfillment services are brick and mortar
retailers seeking support for their e-commerce initiatives in the DVD and CD
markets. For these clients, which include barnesandnoble.com, amazon.com and
bestbuy.com, we offer a comprehensive e-commerce platform, which includes direct
customer product delivery, real-time inventory querying and commitment
capabilities, credit card processing and settlement services, custom packaging,
promotional inserts and customer care services. Other fulfillment services
clients furnish magazines to us, rather than purchasing the product from us,
which we then package into individual orders and ship directly to individual
retail outlets.
Category Management Services. For retailers seeking a total merchandising
solution, we offer category management services that include product selection
and preparation, fixturing, in-store stocking and replenishment, marketing and
promotional program development, and inventory control.
IN-STORE SERVICES
The In-Store Services group provides rebate and other incentive payment
collection, information services and display fixture design and manufacture.
Claim Submission Services. Claim submission services have been the historical
core of our business. U.S. and Canadian retailers engage our In-Store Services
group to accurately monitor, document, claim and collect publisher rebate and
other incentive payments. Our services are designed to relieve our clients of
the substantial administrative burden associated with documenting, verifying and
collecting their payment claims, and to collect a larger percentage of the
potential incentive payments available to the retailers.
We established our Advance Pay Program as an enhancement to our claim
submission services. Typically, retailers are required to wait a significant
period of time to receive payments on their claims for incentive rebates. We
improve the retailer's cash flow by advancing the claims for rebates and other
incentive payments filed by us on their behalf, less our commission, within a
contractually agreed upon period after the end of each quarter.
Information Services. In connection with our claim submission services, we
gather extensive information on magazine sales, pricing, new titles,
discontinued titles and display configurations on a chain-by-chain and
store-by-store basis. As a result, we are able to furnish our clients with
reports of total sales, sales by class of trade and sales by retailer, as well
as reports of unsold magazines and total sales ranking. One of our products, the
Cover Analyzer, permits subscribers to determine the effectiveness of particular
magazine covers on sales for 300 top selling titles in the United States. Our
website gives subscribers the capability to react more quickly to market
changes, including the ability to reorder copies of specific issues, track
pricing information, to introduce new titles, and act on promotions offered by
publishers. Publishers also use the website to promote special incentives and
advertise and display special editions, new publications and upcoming covers. We
have supplemented our own data with data obtained under agreements with Barnes &
Noble, Inc., Walgreen Company and The Kroger Company.
Front-End and Point-of-Purchase Display Fixtures. To enhance retailers'
marketing efficiency, we developed the capacity to design, manufacture, deliver
and dispose of custom front-end and point-of-purchase displays for both retail
store chains and product manufacturers. Retailers perceive our experience in
developing and implementing product display strategies supported by our
information services as helpful in improving the revenue they generated from the
sale of home entertainment content merchandise. In addition, we believe that our
influence on the design and manufacture of display fixtures enhances our ability
to incorporate features that facilitate the gathering of information. Our
services in this regard frequently include designing front-end display fixtures,
supervising fixture
5
installation, selecting products and negotiating, billing and collecting
incentive payments from vendors. We frequently assist our retailer clients in
the development of specialized marketing and promotional programs, which include
special mainline or front-end displays and cross-promotions of magazines and
products of interest to the readers of these magazines. Raw materials used in
manufacturing our fixtures include wire, wood, powder coating, paints and
stains, metal tubing and paneling, wood veneer and laminates, all of which are
readily available from multiple sources.
CUSTOMERS
Our customers in the specialty retail market consist of bookstore chains,
music stores and other specialty retailers. Our customers in the mainstream
retail market consist primarily of grocery stores, drug stores and mass
merchandise retailers. Two customers account for a large percentage of our total
revenues. Barnes & Noble, Inc. accounted for 28.7%, 28.3% and 30.0% in the
fiscal years ended January 31, 2005, 2004 and 2003 respectively. Borders Group,
Inc. accounted for 24.5%, 25.1% and 27.9% of total revenues in the fiscal years
ended January 31, 2005, 2004 and 2003, respectively. Prior to the consummation
of the merger Alliance's customers included specialty retailers, mainstream
retailers, and e-commerce retailers. Alliance's largest customer was Barnes &
Noble, Inc., which historically had accounted for approximately 30% of
Alliance's net sales. Based on historical trends, sales to Barnes & Noble, Inc.
would have represented approximately 30% of the combined company's total
revenues for the fiscal year ended January 31, 2005.
MARKETING AND SALES
Our target market includes magazine publishers, film studios, record labels,
magazine distributors and retailers. We specialize in providing nationwide home
entertainment product distribution to retailers with a national or regional
scope. We believe that our distribution centers differentiate us from our
national competitors and are a key element in our marketing program. Our
distribution centers focus on our just-in-time replenishment and our ability to
deliver product, particularly magazines published on a weekly basis, overnight
to virtually any location within the continental United States.
While we frequently attend trade shows and advertise in trade publications,
we emphasize personal interaction between our sales force and customers so that
our customers are encouraged to rely on our dependability and responsiveness.
Sales of our magazine products are not particularly seasonal; however, sales of
DVDs, CDs and other home entertainment content is highly concentrated in the
fourth fiscal quarter. Historically, prior to its merger with us, approximately
30% of Alliance's net sales were generated in the fourth quarter coinciding with
the holiday shopping season.
To enhance the frequency of contact between our sales force and our
customers, we have organized our direct sales force into a unified marketing
group responsible for soliciting sales of all products and services available
from each of our operating groups. We believe this combined marketing approach
will enhance cross-selling opportunities and lower the cost of customer
acquisition.
COMPETITION
Each of our business units faces significant competition. Our Supply Chain
Management group distributes home entertainment product in competition with a
number of national and regional companies, including Anderson News Company,
Anderson Merchandisers, L.P., Hudson News Company, News Group, Ingram Book
Group, Inc., Ingram Entertainment, Inc., Handleman Company, and Baker & Taylor,
Inc. Major record labels and film studios increasingly compete with us by
establishing direct trading relationships with the larger retail chains and it
is possible that magazine publishers and printers could seek to enter the
magazine distribution business.
Our In-Store Services group has a limited number of direct competitors for
its claims submission program, and it competes in a highly fragmented industry
with other manufacturers for wood and wire display fixture business. In
addition, some of this group's information and management services may be
performed directly by publishers and other vendors, retailers or distributors.
Other information service providers, including A.C. Nielsen Company, Information
Resources and Audit Bureau of Circulations, also collect sales data from retail
stores. If these service
6
providers were to compete with us, given their expertise in collecting
information and their industry reputations, they could be formidable
competitors.
The principal competitive factors faced by each of our business units are price,
financial stability, breath of products and services and reputation.
MANAGEMENT INFORMATION SYSTEMS
The efficiency of our business units are supported by our information systems
that combine traditional outbound product counts with real-time register
activity. Our ability to access real-time register data enables us to quickly
adjust individual store merchandise allocations in response to variation in
consumer demand. This increases the probability that any particular merchandise
allotment will be sold rather than returned for credit. In addition, we have
developed sophisticated database management systems designed to track various
on-sale and off-sale dates for the numerous issues and regional versions of the
magazine titles that we distribute.
Our primary operating systems are built on an open architecture platform and
provide the high level of scalability and performance required to manage our
large and complex business operations. We acquired certain of these systems in
connection with our acquisition of Alliance, including proprietary, real-time,
fully integrated enterprise planning, warehouse management and retail inventory
management systems.
We also deploy a variety of additional hardware and software to manage our
business, including a complete suite of electronic data interchange tools that
enable us to take client orders, transmit advanced shipping notifications, and
place orders with our manufacturing trading partners. We also use an automated
e-mail response system and automated call distribution system to manage our call
center and conduct customer care services.
Software used in connection with our claims submission program and in
connection with our subscriber information website was developed specifically
for our use by a combination of in-house software engineers and outside
consultants. We believe that certain elements of these software systems are
proprietary to us. Other portions of these systems are licensed from a third
party that assisted in the design of the system. We also receive systems service
and upgrades under the license. We believe that we have obtained all necessary
licenses to support our information systems.
We employ various security measures and backup systems designed to protect
against unauthorized use or failure of our information systems. Access to our
information systems is controlled through firewalls and passwords, and we
utilize additional security measures to safeguard sensitive information.
Additionally, we have backup power sources for blackouts and other emergency
situations. Although we have never experienced any material failures or downtime
with respect to any systems operations, any systems failure or material downtime
could prevent us from taking orders and/or shipping product.
We have made strategic investments in material handling automation. Such
investments include computer-controlled order selection systems that provide
labor efficiencies and increase productivity and handling efficiencies. We have
also invested in specialized equipment for our rapidly growing e-commerce
accounts. We believe that in order to remain competitive, it will be necessary
to invest and upgrade from time to time all of our information systems.
EMPLOYEES
As of March 31, 2005, we had 2,473 employees, of whom 2,227 were full-time
employees. Approximately 164 of our employees are covered by collective
bargaining agreements. We believe our relations with our employees are good.
RECENT DEVELOPMENTS
Merger of Source Interlink with Alliance
7
On February 28, 2005, we completed the merger with Alliance Entertainment
Corp, a logistics and supply chain management services company for the home
entertainment product market. In connection with the merger we issued
approximately 26.9 million shares of our common stock to the former Alliance
stockholders and assumed options, warrants and other obligations to issue
approximately 0.9 shares of our common stock.
Alliance historically operated two business segments: the Distribution and
Fulfillment Services Group and the Digital Media Infrastructure Services Group.
Prior to the merger, on December 31, 2004, Alliance disposed of all of the
operations conducted by the Digital Media segment. Consequently, in completing
the merger, we acquired only the Distribution and Fulfillment business, but
retained access to the Digital Media technology through a 5-year licensing
agreement. The Digital Media business represented approximately 1.8% and 1.4% of
Alliance's consolidated sales for the years ended December 31, 2004 and 2003,
respectively.
We consummated the merger with Alliance to further our objective of creating
the premier provider of information, supply chain management and logistics
services to retailers and producers of home entertainment content products. We
expect to benefit from substantial cost savings in the areas of procurement,
marketing, information technology and administration and from other operational
efficiencies, particularly in the distribution and fulfillment functions, where
we plan to consolidate some distribution operations, reorganize others and
leverage our best practices across all of our distribution operations.
Reincorporation from Missouri into Delaware
Also, on February 28, 2005, we reincorporated our company from Missouri into
Delaware (the "Reincorporation"). The Reincorporation was adopted and approved
at a special meeting of our shareholders. Each stock certificate representing
our issued and outstanding shares prior to the Reincorporation will continue to
represent the same number of our shares after the Reincorporation. The
Reincorporation did not result in any change in our name, headquarters,
business, jobs, management, location of offices or facilities, number of
employees, assets, liabilities or net worth. Our common stock continues to be
traded on the Nasdaq National Market under the symbol "SORC."
As a result of the Reincorporation, the rights of our stockholders became
subject to and are now governed by Delaware law, a new certificate of
incorporation and new bylaws. Certain differences in the rights of stockholders
arise from distinctions between Missouri law and Delaware law, as well as from
differences between the charter instruments of our Company. These differences
are described in the section entitled "Comparison of Stockholder Rights and
Corporate Governance Matters" on pages 149-165 of the Registrant's Registration
Statement on Form S-4/A filed on January 18, 2005, which section is incorporated
herein by reference.
Letter of Intent to Acquire Chas. Levy Circulating Co.
On March 18, 2005, we signed a non-binding letter of intent to acquire all of
the outstanding equity interests of Chas. Levy Circulating Co., LLC from its
sole member, Chas. Levy Company, LLC, for a purchase price of approximately $30
million, subject to certain adjustments. Chas. Levy Circulating Co. is one of
the principal magazine wholesalers in the United States and distributes
magazines from all leading publishers to more than 9,000 store fronts operated
by leading retail chains throughout the midwest, east and west coasts. In its
fiscal year ended September 30, 2004, Chas. Levy Circulating Co. reported
revenues of approximately $370 million. Completion of the proposed transaction
is conditioned on satisfactory completion of due diligence and approval of each
company's board of directors
Concurrent with the proposed acquisition, we intend to enter into a separate
10-year marketing and service agreement with Levy Home Entertainment, LLC., a
Chas Levy company not included in the transaction. Levy Home Entertainment is a
full line book distributor.
RISK FACTORS THAT MIGHT AFFECT FUTURE OPERATING RESULTS AND FINANCIAL CONDITION.
8
Set forth below and elsewhere in this Annual Report on Form 10-K and in other
documents we file with the SEC are risks and uncertainties that could cause
actual results to differ materially from the results contemplated by the forward
looking statements contained in this Annual Report on Form 10-K.
RISKS RELATING TO THE BUSINESS
WE HAVE A CONCENTRATED CUSTOMER BASE AND OUR REVENUES COULD BE ADVERSELY
AFFECTED IF IT LOSES ANY OF ITS LARGEST CUSTOMERS OR IF THESE CUSTOMERS ARE
UNABLE TO PAY AMOUNTS DUE TO US.
A significant percentage of our sales are derived from a limited number of
customers. In particular, for the year ended January 31, 2005, Barnes & Noble,
Inc. and Borders Group, Inc. accounted for approximately 28.7% and 24.5% of our
total revenues, respectively.
Alliance also has a significant concentration of revenues from its largest
customers. Historically, Barnes & Noble, Inc. accounted for more than 30% of
Alliance's total net revenues. We believe that as a result of the merger our
customer base may become even more highly concentrated as sales to Barnes &
Noble, Inc. increase as a percentage of our total revenues. Based on historical
trends, sales to Barnes & Noble, Inc. would have represented approximately 30%
of our total revenues for the fiscal year ended January 31, 2005.
As a result of this customer concentration, we expect to be dependent on a
small number of customers for a substantial portion of our revenues. If any of
these customers were to terminate their relationship with us, significantly
reduce their purchases from us or experience problems in paying amounts due to
us, it would result in a material reduction in our revenues and operating
profits.
WE DEPEND ON ACCESS TO CREDIT.
We will have significant working capital requirements principally to finance
inventory and accounts receivables. We are currently a party to a revolving
credit facility and term loan with Wells Fargo Foothill, Inc. In addition, we
are extended trade credit by our suppliers.
Our business will depend on the availability of a credit facility and
continued extension of credit by suppliers to support our working capital
requirements. To maintain the right to borrow revolving loans and avoid a
default under a credit facility, we will be required to comply with various
financial and operating covenants and maintain sufficient eligible assets to
support revolving loans pursuant to a specified borrowing base. Our ability to
comply with these covenants or maintain sufficient eligible assets may be
affected by events beyond our control, including prevailing economic, financial
and industry conditions, and we may be unable to comply with these covenants or
maintain sufficient eligible assets in the future. A breach of any of these
covenants or the failure to maintain sufficient eligible assets could result in
a default under these credit facilities. If we default, our revolving lender
will no longer be obligated to extend revolving loans to us and could declare
all amounts outstanding under our credit facility, together with accrued
interest, to be immediately due and payable. If we were unable to repay those
amounts, our lender could proceed against the collateral granted to it to secure
that indebtedness. The results of such actions would have a significant negative
impact on our results of operations and financial condition.
A DISRUPTION IN THE OPERATIONS OF OUR KEY SHIPPERS COULD CAUSE A DECLINE IN
OUR SALES OR A REDUCTION IN OUR EARNINGS.
We are dependent on commercial freight carriers, primarily Federal Express
and UPS, to deliver our products. If the operations of these carriers are
disrupted for any reason, we may be unable to deliver our products to our
customers on a timely basis. If we cannot deliver our products in an efficient
and timely manner, our revenues and operating profits could suffer.
For the year ended January 31, 2005, our freight cost represented
approximately 5.9% of our revenue. Alliance's freight costs have historically
been approximately 3.0% of its revenue. If freight costs were to increase and we
were unable to pass that increase along to our customers due to competition
within our industry, our financial results could materially suffer.
9
OUR STRATEGY WILL INCLUDE MAKING ADDITIONAL ACQUISITIONS THAT MAY PRESENT
RISKS TO THE BUSINESS.
Making additional strategic acquisitions, such as that of Chas. Levy
Circulating Co., is part of our strategy. The ability to make acquisitions will
depend upon identifying attractive acquisition candidates and, if necessary,
obtaining financing on satisfactory terms. Acquisitions, including those that we
have already made, may pose certain risks to us. These include the following:
- we may be entering markets in which we have limited experience;
- the acquisitions may be potential distractions to management and may
divert company resources and managerial time;
- it may be difficult or costly to integrate an acquired business'
financial, computer, payroll and other systems into our own;
- we may have difficulty implementing additional controls and information
systems appropriate for a growing company;
- some of the acquired businesses may not achieve anticipated revenues,
earnings or cash flow;
- we may have unanticipated liabilities or contingencies from an acquired
business;
- we may have reduced earnings due to amortization expenses, goodwill
impairment charges, increased interest costs and costs related to the
acquisition and its integration;
- we may finance future acquisitions by issuing common stock for some or all
of the purchase price which could dilute the ownership interests of the
stockholders;
- acquired companies will have to become, within one year of their
acquisition, compliant with SEC rules relating to internal control over
financial reporting adopted pursuant to the Sarbanes-Oxley Act of 2002;
- we may be unable to retain management and other key personnel of an
acquired company; and
- we may impair relationships with an acquired company's employees,
suppliers or customers by changing management.
To the extent that the value of the assets acquired in any prior or future
acquisitions, including goodwill or intangible assets with indefinite lives,
becomes impaired, our company would be required to incur impairment charges that
would affect earnings. Such impairment charges could reduce our earnings and
have a material adverse effect on the market value of our common stock. For
example, in connection with our fiscal 2002 acquisition of a magazine
distribution company, we recorded an asset impairment charge totaling $78.1
million.
If we are unsuccessful in meeting the challenges arising out of our
acquisitions, our business, financial condition and future results could be
materially harmed.
WE DEPEND ON ACCESS TO ACCURATE INFORMATION ON RETAIL SALES OF MAGAZINES IN
ORDER TO OFFER CERTAIN SERVICES TO OUR CUSTOMERS, AND WE COULD LOSE A
SIGNIFICANT COMPETITIVE ADVANTAGE IF OUR ACCESS TO SUCH INFORMATION WERE
DIMINISHED.
We use information concerning the retail sales of single copy magazines to:
- compare the revenue potential of various front-end fixture designs to
assist our customers in selecting designs intended to maximize sales in
the front-end;
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- identify sales trends at individual store locations permitting us to
provide just-in-time inventory replenishment and prevent stock outs;
and
- offer both retailers and publishers information services, such as
ICN and Cover Analyzer, and customized sales reporting.
As a result of the merger, we expect to provide similar services with
respect to home entertainment content products which would require us to obtain
and use information regarding these products. We gain access to this information
principally through relationships with A.C. Nielsen & Company and Barnes &
Noble, Inc. We do not currently have written agreements with these providers. We
also obtain a significant amount of information in connection with our rebate
claim submission services. Our access to information could be restricted as a
result of the inability of any of our data partners to supply information to us
or as a result of the discontinuation or substantial modification of the current
incentive payment programs for magazines. If our access to information were
reduced, the value of our information and design services could materially
diminish and our publisher and retailer relationships could be negatively
impacted.
OUR REVENUE FROM THE SALES OF DVDS AND CDS MAY SUFFER DUE TO A SHIFT IN
CONSUMER DEMAND AWAY FROM PHYSICAL MEDIA AND TOWARD DIGITAL DOWNLOADING AND
OTHER DELIVERY METHODS.
Current technology allows consumers to buy music digitally from many
providers such as Apple Computer (through iTunes), Music Match, Rhapsody,
Microsoft (through MSN) and others. The sale of digital music has grown
significantly in the past year, and the recording industry saw sales for CDs
decline significantly from 2001 to 2003. As this method of selling music
increases in popularity and gains consumer acceptance, it may adversely impact
our sales and profitability. The recording industry also continues to face
difficulties as a result of illegal online file-sharing and downloading. While
industry associations and manufacturers have launched legal action against
downloaders and file sharers to stop this practice, there can be no assurance of
the outcome or effect of these lawsuits. File sharing and downloading, both
legitimate and illegal, could continue to exert pressure on the recording
industry and the demand for CDs. Additionally, as other forms of media become
available for digital download, our sales and profitability attributable to our
CDs may be adversely affected.
Recent advances in the technologies to deliver movies to viewers may
adversely affect public demand for DVDs offered by us. For example, some digital
cable providers and internet companies offer movies "on demand" with interactive
capabilities such as start, stop and rewind. Direct broadcast satellite and
digital cable providers have been able to enhance their on-demand offerings as a
result of their ability to transmit over numerous channels. Apart from on-demand
technology, the recent development and enhancement of personal video recorder
technology with "time-shifting" technology (such as that used by TiVo and
certain cable companies) has given viewers greater interactive control over
broadcasted movies and other program types. Also, companies such as Blockbuster
Entertainment and NetFlix are now offering subscription services which provide
consumers the ability to rent VHS cassettes and DVDs for indefinite periods of
time without being subject to late fees. If these methods of watching filmed
entertainment increase in popularity and gain consumer acceptance, they may
adversely impact sales and profits.
WE PARTICIPATE IN HIGHLY COMPETITIVE INDUSTRIES AND COMPETITIVE PRESSURES
MAY RESULT IN A DECREASE IN OUR REVENUES AND PROFITABILITY.
Each of our business units faces significant competition. Our Supply Chain
Management group distributes home entertainment product in competition with a
number of national and regional companies, including Anderson News Company,
Anderson Merchandisers, L.P., Hudson News Company, News Group, Ingram Book
Group, Inc., Ingram Entertainment, Inc., Handleman Company, and Baker & Taylor,
Inc. Major record labels and film studios increasingly compete with us by
establishing direct trading relationships with the larger retail chains and it
is possible that magazine publishers and printers could seek to enter the
magazine distribution business.
Our In-Store Services group has a limited number of direct competitors for
its claims submission program, and it competes in a highly fragmented industry
with other manufacturers for wood and wire display fixture business. In
addition, some of this group's information and management services may be
performed directly by publishers and other vendors, retailers or distributors.
Other information service providers, including A.C. Nielsen Company,
11
Information Resources and Audit Bureau of Circulations, also collect sales data
from retail stores. If these service providers were to compete with us, given
their expertise in collecting information and their industry reputations, they
could be formidable competitors.
Some of our existing and potential competitors have substantially greater
resources and greater name recognition than we do with respect to the market or
market segments they serve. Because of each of these competitive factors, we may
not be able to compete successfully in these markets with existing or new
competitors. Competitive pressures may result in a decrease in the number of
customers it serves, a decrease in its revenues or a decrease in its operating
profits.
WE CONDUCT A GROWING PORTION OF OUR BUSINESS INTERNATIONALLY, WHICH
PRESENTS ADDITIONAL RISKS TO US OVER AND ABOVE THOSE ASSOCIATED WITH ITS
DOMESTIC OPERATIONS.
Approximately 10.8% of our total revenues for the year ended January 31,
2005 were derived from the export of U.S. publications to overseas markets,
primarily to the United Kingdom and Australia. In addition, approximately 17.9%
of our gross domestic distribution for the year ended January 31, 2005,
consisted of the domestic distribution of foreign publications imported for sale
to U.S. markets. A growing portion of Alliance's revenues were also derived from
international sales. Historically, approximately 13% of Alliance's total net
revenues were derived from international customers.
The conduct of business internationally presents additional inherent risks
including:
- unexpected changes in regulatory requirements;
- import and export restrictions;
- tariffs and other trade barriers;
- differing technology standards;
- resistance from retailers to our business practices;
- employment laws and practices in foreign countries;
- political instability;
- fluctuations in currency exchange rates;
- imposition of currency exchange controls; and
- potentially adverse tax consequences.
Any of these risks could adversely affect revenue and operating profits of
our international operations.
Certain suppliers have adopted policies restricting the export of DVDs and
CDs by domestic distributors. However, consistent with industry practice, we
distribute our merchandise internationally. We would be adversely affected if a
substantial portion of our suppliers enforced any restriction on our ability to
sell our home entertainment content products outside the United States.
A SUBSTANTIAL MAJORITY OF MAGAZINES DISTRIBUTED BY US ARE PURCHASED FROM
FOUR SUPPLIERS AND OUR REVENUES COULD BE ADVERSELY AFFECTED IF WE ARE UNABLE TO
RECEIVE MAGAZINE ALLOTMENTS FROM THESE SUPPLIERS.
Substantially all of the magazines distributed in the United States are
supplied by or through one of four national distributors, Comag Marketing Group,
LLC, Curtis Circulation Company, Kable Distribution Services, Inc. and Warner
Publisher Services, Inc. Each title is supplied by one of these national
distributors to us and cannot be purchased from any alternative source. Our
success is largely dependent on our ability to obtain product in sufficient
12
quantities on competitive terms and conditions from each of the national
distributors. In order to qualify to receive copy allotments, we are required to
comply with certain operating conditions, which differ between the specialty
retail market and the mainstream market. Our ability to economically satisfy
these conditions may be affected by events beyond our control, including the
cooperation and assistance of our customers. A failure to satisfy these
conditions could result in a breach of our purchase arrangements with our
suppliers and entitle our suppliers to reduce our copy allotment or discontinue
our right to receive product for distribution to our customers. If our supply of
magazines were reduced, interrupted or discontinued, customer service would be
disrupted and existing customers may reduce or cease doing business with us
altogether, thereby causing our revenue and operating income to decline and
result in failure to meet expectations.
IF WE WERE UNABLE TO RECEIVE OUR PRODUCTS FROM OUR TOP SUPPLIERS, OUR
SALES AND PROFITABILITY COULD BE ADVERSELY AFFECTED.
A substantial portion of the DVD and CD products distributed by us are
supplied by 5 film studios and 4 record labels. These products are proprietary
to individual suppliers and may not be obtained from any alternative source. Our
success depends upon our ability to obtain product in sufficient quantities on
competitive terms and conditions from each of these major home entertainment
labels and studios. If our supply of products were interrupted or discontinued,
then customer service could be adversely affected and customers may reduce or
cease doing business with us causing our sales and profitability to decline.
VIRTUALLY ALL OF OUR SALES WILL BE MADE ON A "SALE OR RETURN" BASIS AND
HIGHER THAN EXPECTED RETURNS COULD CAUSE US TO OVERSTATE REVENUE FOR THE PERIOD
AFFECTED.
As is customary in the home entertainment content product industry,
virtually all of our sales will be made on a "sale or return" basis. During the
year ended January 31, 2005, approximately 55 out of every 100 magazine copies
distributed domestically by Source Interlink and between approximately 15 and 18
out of every 100 DVDs and CDs, respectively, distributed domestically by
Alliance were returned unsold by their customers for credit; however, the
sell-through rate has historically varied from period to period. Revenues from
the sale of merchandise that we distribute are recognized at the time of
delivery, less a reserve for estimated returns. The amount of the return reserve
is estimated based on historical sell-through rates. If sell-through rates in
any period are significantly less than historical averages, this return reserve
could be inadequate. If the return reserve proved inadequate, it would indicate
that actual revenue in prior periods was less than accrued revenue for such
periods. This would require an increase in the amount of the return reserve for
subsequent periods which may result in a reduction in operating income for such
periods.
SALES OF DVDS AND CDS ARE HIGHLY SEASONAL, AND FINANCIAL RESULTS COULD BE
NEGATIVELY IMPACTED IF ITS FOURTH QUARTER'S SALES ARE WEAK.
Alliance has historically generated approximately 33% of its total net
sales in the fourth calendar quarter of 2004 coinciding with the holiday
shopping season. Factors that could adversely affect sales and profitability in
the fourth quarter include:
- unavailability of, and low customer demand for, particular products;
- unfavorable economic conditions;
- inability to hire adequate temporary personnel;
- inability to anticipate consumer trends; and
- inability to maintain adequate inventory levels.
WE DEPEND ON THE EFFORTS OF CERTAIN KEY PERSONNEL, THE LOSS OF WHOSE
SERVICES COULD ADVERSELY AFFECT OUR BUSINESS.
We depend upon the services of our chief executive officer and chief
operating officer and their relationships with customers and other third
parties. The loss of these services or relationships could adversely affect our
business
13
and the implementation of our growth strategy. This in turn could materially
harm our financial condition and future results. Although we have employment
agreements with each of our chief executive officer and chief operating officer,
the services of these individuals may not continue to be available to the
combined company. We carry key person life insurance on the lives of both our
chief executive officer and chief operating officer.
OUR MANAGEMENT AND INTERNAL SYSTEMS MIGHT BE INADEQUATE TO HANDLE OUR
POTENTIAL GROWTH.
To manage future growth, including growth resulting from the merger, our
management must continue to improve operational and financial systems and
expand, train, retain and manage its employee base. We will likely be required
to manage an increasing number of relationships with various customers and other
parties. Our management may not be able to manage the company's growth
effectively. If our systems, procedures and controls are inadequate to support
our operations, our expansion could be halted and we could lose opportunities to
gain significant market share. Any inability to manage growth effectively may
harm our business.
OUR OPERATIONS COULD BE DISRUPTED IF OUR INFORMATION SYSTEMS FAIL, CAUSING
INCREASED EXPENSES AND LOSS OF SALES.
Our business depends on the efficient and uninterrupted operation of our
computer and communications software and hardware systems, including our
replenishment and order regulation systems, and other information technology. If
we were to fail for any reason or if we were to experience any unscheduled down
times, even for only a short period, its operations and financial results could
be adversely affected. We and Alliance have in the past experienced performance
problems and unscheduled down times, and these problems could recur. Our systems
could be damaged or interrupted by fire, flood, hurricanes, power loss,
telecommunications failure, break-ins or similar events. We have formal disaster
recovery plans in place. However, these plans may not be entirely successful in
preventing delays or other complications that could arise from information
systems failure, and, if they are not successful, our business interruption
insurance may not adequately compensate it for losses that may occur.
WE DEPEND ON THE INTERNET TO DELIVER SOME OF OUR SERVICES, AND THE USE OF
THE INTERNET MAY EXPOSE US TO INCREASED RISKS.
Many of our operations and services, including replenishment and order
regulation systems, PIN, ICN, customer direct fulfillment and other information
technology, involve the transmission of information over the Internet. Our
business therefore will be subject to any factors that adversely affect Internet
usage including the reliability of Internet service providers, which from time
to time have operational problems and experience service outages.
In addition, one of the requirements of the continued growth over the
Internet is the secure transmission of confidential information over public
networks. Failure to prevent security breaches of our networks or those of our
customers or well-publicized security breaches affecting the Internet in general
could significantly harm our growth and revenue. Advances in computer
capabilities, new discoveries in the field of cryptography or other developments
may result in a compromise or breach of the algorithms we use to protect content
and transactions or our customers' proprietary information in its databases.
Anyone who is able to circumvent our security measures could misappropriate
proprietary and confidential information or could cause interruptions in our
operations. We may be required to expend significant capital and other resources
to protect against such security breaches or to address problems caused by
security breaches.
14
IF OUR ACCOUNTING CONTROLS AND PROCEDURES ARE CIRCUMVENTED OR OTHERWISE
FAIL TO ACHIEVE THEIR INTENDED PURPOSES, OUR BUSINESS COULD BE SERIOUSLY HARMED.
Although we evaluate our internal control over financial reporting and
disclosure controls and procedures as of the end of each fiscal quarter, we may
not be able to prevent all instances of accounting errors or fraud in the
future. Controls and procedures do not provide absolute assurance that all
deficiencies in design or operation of these control systems, or all instances
of errors or fraud, will be prevented or detected. These control systems are
designed to provide reasonable assurance of achieving the goals of these systems
in light of legal requirements, company resources and the nature of our business
operations. These control systems remain subject to risks of human error and the
risk that controls can be circumvented for wrongful purposes by one or more
individuals in management or non-management positions. Our business could be
seriously harmed by any material failure of these control systems.
THE DVD AND CD BUSINESS DEPENDS IN PART ON THE CURRENT ADVERTISING
ALLOWANCES, VOLUME DISCOUNTS AND OTHER SALES INCENTIVE PROGRAMS, AND ITS RESULTS
OF OPERATION COULD BE ADVERSELY AFFECTED IF THESE PROGRAMS WERE DISCONTINUED OR
MATERIALLY MODIFIED.
Under terms of purchase prevailing in its industry, the profitability of
the DVD and CD are enhanced by advertising allowances, volume discounts and
other sales incentive programs offered by record labels and movie studios. Such
content providers are not under long-term contractual obligations to continue
these programs, and in 2003 one major record label eliminated advertising
allowances and volume discounts on a limited number of stock keeping units. If
record labels or movie studios, or both, decide to discontinue these programs,
we would experience a significant reduction in operating profits.
RISKS RELATING TO THE MERGER BETWEEN SOURCE INTERLINK AND ALLIANCE ENTERTAINMENT
CORP.
WE MAY NOT REALIZE SOME OF THE EXPECTED BENEFITS OF THE MERGER OF SOURCE
INTERLINK AND ALLIANCE.
We believe that the merger provides significant market opportunities to
take advantage of the customer bases and distribution channels of the formerly
separate businesses of Source Interlink and Alliance Entertainment in order to
promote and sell the products and services of one company to the existing
customers and business partners of the other company. However, we may be unable
to take advantage of these cross-selling opportunities and other revenue
synergies for several reasons. Difficulties in integrating the two companies
could result in disruption of customer services, which could cause existing
customers to reduce or cease doing business with the combined company
altogether. Moreover, the salespersons of one company may not be successful in
marketing the products and services of the other company or the existing
customers and business partners of either company may not be receptive to the
products and services of the other.
We also expect to benefit from substantial cost savings in the areas of
procurement, marketing, information technology and administration and from other
operational efficiencies. We may not realize these savings within the time
periods contemplated, or at all. If the benefits of the merger do not exceed the
associated costs, or if costs related to the merger exceed estimates, our
business and financial results could be materially harmed.
WE MAY BE UNABLE TO INTEGRATE THE OPERATIONS OF SOURCE INTERLINK AND
ALLIANCE SUCCESSFULLY.
We are in the process of integrating two companies that previously have
operated independently, which is a complex, costly and time-consuming process.
The difficulties of combining the companies' operations include, among other
things:
- the necessity of coordinating geographically disparate
organizations, systems and facilities;
- integrating personnel with diverse business backgrounds;
- consolidating corporate and administrative functions;
- limiting the diversion of management resources necessary to
facilitate the integration;
15
- implementing compatible information and communication systems, as
well as common operating procedures;
- creating compatible financial controls and comparable human
resources practices;
- coordinating sales and marketing functions;
- maintaining customer care services and retaining key customers;
- retaining key management and employees; and
- preserving the collaboration, distribution, marketing, promotion and
other important relationships of each company.
The process of integrating operations could cause an interruption of, or
loss of momentum in, the activities of our business and the loss of key
personnel. The diversion of management's attention, any delays or difficulties
encountered in connection with the merger and the integration of the two
companies' operations or the costs associated with these activities could harm
our business, results of operations, financial condition or prospects.
THE MARKET PRICE OF OUR COMMON STOCK MAY DECLINE AS A RESULT OF THE
MERGER.
The market price of our common stock may decline as a result of the merger
for a number of reasons, including if:
- the integration of our company and Alliance is not completed in a
timely and efficient manner;
- the costs associated with the merger or the integration of our
company and Alliance are higher than anticipated;
- we do not achieve the perceived benefits of the merger as rapidly or
to the extent anticipated by financial or industry analysts or
investors; or
- the effect of the merger on our financial results is not consistent
with the expectations of financial or industry analysts or
investors.
THERE MAY BE SALES OF A LARGE NUMBER OF SHARES OF OUR COMMON STOCK AFTER
THE MERGER THAT COULD CAUSE OUR STOCK PRICE TO FALL.
A large number of shares of our common stock may be sold into the public
market within short periods of time at various dates following the closing of
the merger. As a result, our stock price could fall. Of the approximately 26.9
million shares of our common stock issued in connection with the merger,
approximately 18.8% of such shares are immediately available for resale by
former stockholders of Alliance and approximately 81.2% of such shares are
subject to "lock-up agreements" that restrict the timing of the resale of these
shares. Under the lock-up agreements, shares will be released and available for
sale in the public market as follows:
- up to 33 1/3% of the shares subject to lock-up agreements may be
sold in the public market after May 28, 2005;
- up to a further 33 1/3% of the shares subject to lock-up agreements
may be sold in the public market after August 28, 2005; and
- the remaining shares subject to lock-up agreements may be sold in
the public market after November 28, 2005.
Any disposition of our common stock by former Alliance stockholders are
also subject to compliance with the Securities Act, including Rules 144 and 145
thereunder. While Rule 145 under the Securities Act may impose some
16
limitations on the number of shares certain Alliance stockholders may sell,
including AEC Associates, sales of a large number of newly released shares of
our common stock could occur and that could result in a sharp decline in our
stock price. In addition, the sale of these shares could impair the combined
company's ability to raise capital through the sale of additional stock.
RISKS RELATED TO YOUR OWNERSHIP OF OUR STOCK
WE HAVE A SIGNIFICANT STOCKHOLDER WHOSE INTERESTS MAY CONFLICT WITH YOURS.
Our largest stockholder, AEC Associates, L.L.C. beneficially owned
approximately 34.7% of our outstanding voting power as of April 13, 2005. AEC
Associates also has the right to designate three nominees for election to the
eleven member board which it is expected to exercise for our 2005 annual
meeting. In addition, for as long as AEC Associates (together with its members
and affiliates acting as a group) owns an aggregate of at least 10% of our
outstanding common stock, AEC Associates will have certain additional director
designation rights as further described in the risk factor entitled "We have
limitations on changes of control that could reduce your ability to sell our
shares at a premium." For example, for actions that require a supermajority of
the board, such as a change of control, AEC Associates designated directors may
effectively have enough votes to prevent any such action from being taken by us.
As a result, AEC Associates will have the ability through its ownership of our
common stock and its representation on the board to exercise significant
influence over our major decisions and over all matters requiring stockholder
approval. AEC Associates may have interests that differ from those of our
stockholders.
OUR BYLAWS WILL REQUIRE SUPERMAJORITY APPROVAL OF OUR BOARD BEFORE WE CAN
TAKE CERTAIN ACTIONS. THIS REQUIREMENT MAY RESTRICT STRATEGIC TRANSACTIONS
INVOLVING US.
Our bylaws provide that the affirmative vote of at least 75% of its entire
board will be required to (i) approve or recommend a reorganization or merger of
our company in a transaction that will result in our stockholders immediately
prior to such transaction not holding, as a result of such transaction, at least
50% of the voting power of the surviving or continuing entity, (ii) a sale of
all or substantially all of our assets which would result in its stockholders
immediately prior to such transaction not holding, as a result of such sale, at
least 50% of the voting power of the purchasing entity, or (iii) a change in our
bylaws. This requirement may prevent us from making changes and taking other
actions that are subject to this supermajority approval requirement. This
requirement may limit our ability to pursue strategies or enter into strategic
transactions for which the supermajority approval of the board cannot be
obtained.
WE HAVE LIMITATIONS ON CHANGES OF CONTROL THAT COULD REDUCE YOUR ABILITY
TO SELL OUR SHARES AT A PREMIUM.
Our certificate of incorporation and bylaws currently contain provisions
that could reduce the likelihood of a change of control or acquisition of our
company, which could limit your ability to sell our shares at a premium or
otherwise affect the price of our common stock. These provisions include the
following:
- permit our board to issue up to 2,000,000 shares of preferred stock
and to determine the price, rights, preferences, privileges and
restrictions of that preferred stock;
- permit our board to issue up to 100,000,000 shares of common stock;
- require that a change of control of the company be approved by a
supermajority of at least 75% of the members of the board;
- provide for a classified board of directors;
- provide that, for as long as AEC Associates (together with its
members and affiliates acting as a group) owns an aggregate of at
least 10% of the combined company's common stock, AEC Associates
will have the right to designate an individual (or individuals) of
its choice for election by the board for any seat that is last
occupied or vacated by a director designated by Alliance or AEC
Associates, except if such designation would result in the directors
designated by AEC Associates having a disproportionate board
representation
17
to AEC Associates' (together with its members and affiliates acting
as a group) ownership of our common stock;
- permit the board to increase its own size and fill the resulting
vacancies;
- limit the persons who may call special meetings of stockholders; and
- establish advance notice requirements for nominations for election
to the board or for proposing matters that can be acted on by
stockholders at stockholders meetings.
OUR COMMON STOCK PRICE HAS BEEN VOLATILE, WHICH COULD RESULT IN
SUBSTANTIAL LOSSES FOR STOCKHOLDERS.
Our common stock is currently traded on the Nasdaq National Market. Our
average daily trading volume for the three month period ending April 13, 2005
was approximately 150,000 shares. In the future, we may experience more limited
daily trading volume. The trading price of our common stock has been and may
continue to be volatile. The closing sale prices of our common stock, as
reported by the Nasdaq National Market, have ranged from a high of $13.58 to a
low of $8.39 for the 52-week period ending January 31, 2005. Broad market and
industry fluctuations may significantly affect the trading price of our common
stock, regardless of our actual operating performance. The trading price of our
common stock could be affected by a number of factors, including, but not
limited to, announcements of new services, additions or departures of key
personnel, quarterly fluctuations in our financial results, changes in analysts'
estimates of our financial performance, general conditions in our industry and
conditions in the financial markets and a variety of other risk factors,
including the ones described elsewhere in this Annual Report on Form 10-K.
Periods of volatility in the market price of a company's securities sometimes
result in securities class action litigation. If this were to happen to us, such
litigation would be expensive and would divert management's attention. In
addition, if we needed to raise equity funds under adverse conditions, it would
be difficult to sell a significant amount of our stock without causing a
significant decline in the trading price of our stock.
ITEM 2. PROPERTIES
Our principal corporate offices are located at 27500 Riverview Center
Boulevard, Bonita Springs, Florida. As of April 13, 2005, we owned or leased
approximately 1.1 million square feet of manufacturing facilities, 1.0 million
square feet of distribution centers and 90,000 square feet of office space. The
following table presents information concerning our principal properties:
LOCATION DESCRIPTION SEGMENT SIZE (sq. ft.) OWNED/ LEASED
- --------------------------- -------------------------- ----------------------- ---------------- -------------
Bonita Springs, FL......... Office Worldwide 62,000 Leased
Headquarters
New York, NY............... Office Supply Chain Management 3,500 Leased
Coral Springs, FL.......... Distribution Center/office Supply Chain Management 250,000 Owned
Shepherdsville, KY......... Distribution Center Supply Chain Management 169,000 Leased
Rockford, IL............... Manufacturing/ Supply Chain 300,000/10,500 Owned
Distribution Center Management/In-store
Services
Brooklyn, NY............... Manufacturing In-Store Services 90,000 Leased
Philadelphia, PA........... Warehouse In-Store Services 110,000 Owned
Vancouver, B.C. ........... Manufacturing In-Store Services 51,000 Leased
Quincy, IL................. Manufacturing In-Store Services 258,000 Owned
Albemarle, NC.............. Manufacturing In-Store Services 190,000 Leased
Dallas, TX................. Distribution Center Supply Chain Management 48,000 Leased
Harrisburg, PA............. Distribution Center Supply Chain Management 142,000 Leased
18
Carson City, NV............ Distribution Center Supply Chain Management 135,000 Leased
Coral Springs, FL.......... Warehouse Supply Chain Management 46,000 Leased
Dayton, NJ................. Distribution.Center Supply Chain Management 42,000 Leased
We believe our facilities are adequate for our current level of operations
and that all of our facilities are adequately insured.
ITEM 3. LEGAL PROCEEDINGS
We are party to routine legal proceedings arising out of the normal course
of business. Although it is not possible to predict with certainty the outcome
of these unresolved legal actions or the range of possible loss, we believe that
none of these actions, individually or in the aggregate, will have a material
adverse effect on our financial condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of stockholders during the fourth
quarter of fiscal 2005.
19
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES.
PRICE RANGE OF COMMON STOCK
Our common stock is quoted on the Nasdaq National Market under the symbol SORC.
The following table sets forth, for the periods indicated, the range of high and
low bid prices for our common stock as reported by the Nasdaq National Market
during the fiscal year shown. All such quotations reflect inter-dealer prices,
without retail mark-up, mark-down or commission and may not necessarily
represent actual transactions.
HIGH LOW
Year ended January 31, 2004
First Quarter $ 5.51 $ 4.33
Second Quarter 8.59 5.50
Third Quarter 9.82 7.70
Fourth Quarter 14.30 8.10
Year ended January 31, 2005
First Quarter $13.58 $10.31
Second Quarter 11.39 8.89
Third Quarter 10.73 8.39
Fourth Quarter 13.32 10.20
As of April 13, 2005, there were approximately 195 holders of record of the
common stock.
DIVIDEND POLICY
We have never declared or paid dividends on our common stock. Our board of
directors presently intends to retain all of our earnings, if any, for the
development of our business for the foreseeable future. The declaration and
payment of cash dividends in the future will be at the discretion of our board
of directors and will depend upon a number of factors, including, among others,
any restrictions contained in our credit facilities and our future earnings,
operations, capital requirements and general financial condition and such other
factors that our board of directors may deem relevant. Currently, our credit
facilities prohibit the payment of cash dividends or other distributions on our
capital stock or payments in connection with the purchase, redemption,
retirement or acquisition of our capital stock.
REPURCHASES OF EQUITY SECURITIES
We did not make any repurchases of our equity securities in the fourth quarter
of 2004.
ITEM 6. SELECTED FINANCIAL DATA.
The following selected consolidated financial data are only a summary and
should be read in conjunction with our financial statements and related notes
thereto and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" included in this Annual Report on Form 10-K. The
consolidated statement of operations data for the years ended January 31, 2003,
2004 and 2005 and the balance sheet data as of January 31, 2004 and 2005, which
have been prepared in accordance with accounting principles generally accepted
in the U.S., are derived from our financial statements audited by BDO Seidman,
LLP, an independent registered public accounting firm, which are included
elsewhere in this Annual Report on Form 10-K. The consolidated statements of
income data for the years ended January 31, 2001 and 2002 and the balance sheet
data as of January 31, 2001, 2002 and 2003, which have been prepared in
accordance with accounting principles generally accepted in the U.S., are
derived from our audited financial statements which are not included in this
Annual Report on Form 10-K. On February 28, 2005, we consummated our merger with
Alliance Entertainment Corp. The results of operations of
20
Alliance are not included in the selected financial data presented below. For a
description of the merger of Source Interlink and Alliance, please see the
section entitled "Management's Discussion and Analysis of Financial Condition
and Results of Operations." Historical operating results are not necessarily
indicative of the results that may be expected for any future period.
YEAR ENDED JANUARY 31,
--------------------------------------------------------------
2001(3) 2002(3) 2003(3) 2004(3) 2005
---------- ---------- ---------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENT OF
OPERATIONS DATA:
Revenues $ 92,423 $ 218,697 $ 269,191 $ 315,791 $ 356,644
Cost of revenues 53,792 159,660 197,431 229,748 258,851
--------- --------- --------- --------- ---------
Gross profit 38,631 59,037 71,760 86,043 97,793
Selling, general and administrative expenses 23,279 36,464 43,710 50,538 55,130
Fulfillment freight - 7,931 14,721 16,381 21,067
Relocation expenses (1) - - 1,926 1,730 2,450
Amortization of goodwill 2,994 5,424 - - -
Goodwill impairment charge (2) - 48,993 - - -
Loss on sale of land and building - - - - (1,122)
--------- --------- --------- --------- ---------
Operating income (loss) 12,358 (39,775) 11,403 17,394 18,024
Other income (expense):
Interest expense (2,312) (2,650) (3,473) (3,427) (1,575)
Interest income - - 277 358 175
Deferred loan costs - - - (865) (1,495)
Other 36 (2,390) 445 393 161
--------- --------- --------- --------- ---------
Total other expense (2,276) (5,040) (2,751) (3,541) (2,734)
--------- --------- --------- --------- ---------
Income from continuing operations before income
taxes and discontinued operation 10,082 (44,815) 8,652 13,853 15,290
Income tax expense (benefit) 3,965 (969) 893 3,690 2,228
--------- --------- --------- --------- ---------
Income from continuing operations before
discontinued operation 6,117 (43,846) 7,759 10,163 13,062
Loss from discontinued operation, net of tax - (29,019) (421) (115) (980)
--------- --------- --------- --------- ---------
Net income (loss) $ 6,117 $ (72,865) $ 7,338 $ 10,048 $ 12,082
========= ========= ========= ========= =========
Earnings (loss) per share - basic
Continuing operations $ 0.35 $ (2.45) $ 0.42 $ 0.55 0.57
Discontinued operations - (1.62) (0.02) (0.01) (0.04)
--------- --------- --------- --------- ---------
Total 0.35 (4.07) 0.40 $ 0.54 0.53
========= ========= ========= ========= =========
Earnings (loss) per share - diluted
Continuing operations 0.33 (2.45) 0.42 0.52 0.53
Discontinued operations - (1.62) (0.02) (0.01) (0.04)
--------- --------- --------- --------- ---------
Total 0.33 (4.07) 0.40 0.51 0.49
========= ========= ========= ========= =========
Weighted average of shares outstanding in computing
Basic net income per share 17,591 17,915 18,229 18,476 22,963
Diluted net income per share 18,348 17,915 18,478 19,866 24,833
========= ========= ========= ========= =========
AT JANUARY 31,
--------------------------------------------------------------
2001 2002 2003 2004 2005
---------- ---------- ---------- ---------- ----------
(IN THOUSANDS)
CONSOLIDATED BALANCE SHEET DATA:
Cash 1,085 2,943 5,570 4,963 1,387
Working capital 60,277 (9,424) (3,519) 19,418 41,186
Total assets 158,448 164,430 157,239 164,101 197,753
Current maturities of debt 116 42,097 29,215 4,059 5,630
Debt, less current maturities 31,780 15,578 17,026 31,541 34,139
Total liabilities 48,658 120,887 106,320 97,027 70,070
Total equity 109,790 43,543 50,919 67,074 127,683
========= ========= ========= ========= =========
(1) Relocation costs relate to the consolidation of our prior offices from St.
Louis, Missouri, High Point, North Carolina and San Diego, California to
our new offices in Bonita Springs, Florida. In addition, during fiscal
2005, the company relocated distribution centers from Milan, OH, San
Diego, CA and Kent, WA to Harrisburg, PA and Carson City, NV.
(2) Charge related to the impairment of the goodwill attributed to our
Magazine Distribution and Wood Manufacturing businesses.
(3) Restated for the discontinued operations as discussed in note 8.
21
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
OVERVIEW
Prior to our merger with Alliance as discussed below, our business
consisted of four business segments: Magazine Fulfillment, In-Store Services,
Wood Manufacturing and Shared Services. Our segment reporting is structured
based on the reporting of senior management to our chief executive officer.
- Our Magazine Fulfillment group provides domestic and foreign titled
magazines to specialty retailers, such as bookstores and music
stores, and to mainstream retailers, such as supermarkets, discount
stores, drug stores, convenience stores and newsstands. This group
also exports domestic titled magazines from more than 100 publishers
to foreign markets worldwide. We provide fulfillment services to
more than 26,000 retail stores, 7,300 of which also benefit from our
selection and logistical procurement services.
- Our In-Store Services group assists retailers with the design and
implementation of their front-end area merchandise programs, which
generally have a three-year life cycle. We also provide other
value-added services to retailers, publishers and other vendors.
These services include assisting retailers with the filing of claims
for publisher incentive payments, which are based on display
location or total retail sales, and providing publishers with access
to real-time sales information on more than 10,000 magazine titles,
thereby enabling them to make more informed decisions regarding
their product placement, cover treatments and distribution efforts.
- Our Wood Manufacturing group designs and manufactures wood display
and store fixtures for leading specialty retailers.
- Our Shared Services group consists of overhead functions not
allocated to the other groups. These functions include corporate
finance, human resource, management information systems and
executive management that are not allocated to the three operating
groups. Upon completion of the consolidation of our administrative
operations, we restructured our accounts to separately identify
corporate expenses that are not attributable to any of our three
main operating groups. Prior to fiscal year 2004, these expenses
were included within our In-Store Services group.
On February 28, 2005, we completed the merger with Alliance Entertainment
Corp, a logistics and supply chain management services company for the home
entertainment product market pursuant to the terms and conditions of the
Agreement and Plan of Merger Agreement dated as of November 18, 2004 (the
"Merger Agreement").
Alliance historically operated two business segments: the Distribution and
Fulfillment Services Group ("DFSG") and the Digital Medial Infrastructure
Services Group (the "DMISG"). Prior to the merger, on December 31, 2004,
Alliance disposed of all of the operations conducted by the DMISG business lines
through a spin-off to its existing stockholders. Consequently, in connection
with the merger, we acquired only the DFSG business and not the DMISG business.
The DMISG business represented approximately 1.8% and 1.4% of Alliance's
consolidated sales for the years ended December 31, 2004 and 2003, respectively.
We consummated the merger with Alliance to further our objective of
creating the premier provider of information, supply chain management and
logistics services to retailers and producers of home entertainment content
products. We believe that the merger provides significant market opportunities
to take advantage of our strong retailer relationships and experience in
marketing our products by expanding product offerings beyond our existing
magazine fulfillment business to DVDs, CDs, video games and related home
entertainment products and accessories. In addition, we believe that our
in-store merchandising capabilities will be strengthened. We also believe this
transaction will position us as the distribution channel of choice for film
studios, record labels, publishers and other producers of home entertainment
content products. We expect to benefit from substantial cost savings in the
areas of procurement, marketing, information technology and administration and
from other operational efficiencies, particularly in the distribution and
fulfillment functions, where we plan to consolidate some distribution
operations, reorganize others and leverage our best practices across all of our
distribution operations. As
22
a result, we believe the merger will enhance our financial strength, increase
our visibility in the investor community and strengthen our ability to pursue
further strategic acquisitions.
The total purchase price of approximately $317.0 million consisted of
$304.7 million in Source Interlink common stock, representing approximately 26.9
million shares, $9.3 million related to the exchange of approximately 0.9
million shares of common stock on exercise of outstanding stock options,
warrants and other rights to acquire Alliance common stock and direct
transaction costs of $3.0 million. The value of the common stock was determined
based on the average market price of Source Interlink common stock over the
5-day period prior to and after the announcement of the merger in November 2004.
The value of the stock options was determined using the Black-Scholes option
valuation model.
DISCONTINUED OPERATION
In November 2004, the Company sold and disposed of its secondary wholesale
distribution operation for $1.4 million, in order to focus more fully on its
domestic and export distribution. All rights owned under the secondary wholesale
distribution contracts were assigned, delivered, conveyed and transferred to the
buyer, an unrelated third party. All assets and liabilities relating to our
secondary wholesale distribution operation were not assumed by the buyer. We
recognized a gain on sale of this business of $1.4 million ($0.8 net of tax) in
the fourth quarter of fiscal year 2005.
The following amounts related to our Magazine Fulfillment segment's discontinued
operation (secondary wholesale distribution business) have been segregated from
continuing operations and reflected as discontinued operations in each period's
consolidated statement of income (in thousands):
2003 2004 2005
---- ---- ----
Revenue $ 21,704 $ 17,343 $ 13,380
======== ======== ========
Loss before income taxes $ (702) $ (191) $ (3,033)
Income tax benefit 281 76 1,213
-------- -------- --------
Loss from discontinued operation, net of tax (421) (115) (1,820)
-------- -------- --------
Pre-tax gain on sale of discontinued business - - 1,400
Income tax expense - - (560)
-------- -------- --------
Gain on sale of business, net of tax - - 840
-------- -------- --------
Discontinued operations, net of tax $ (421) $ (115) $ (980)
======== ======== ========
23
REVENUES
The Magazine Fulfillment group derives revenues from:
- selling and distributing magazines, including domestic and foreign
titles, to specialty and mainstream retailers throughout the United
States and Canada;
- exporting domestic titles internationally to foreign wholesalers or
through domestic brokers;
- providing return processing services for major specialty retail book
chains; and
- serving as an outsourced fulfillment agent and backroom operator for
publishers.
The In-Store Services group derives revenues from:
- designing, manufacturing and invoicing participants in front-end
merchandising programs;
- providing claim filing services related to rebates owed to retailers
from publishers or their designated agents;
- storing, shipping, installing, and removing front-end fixtures; and
- providing information and management services relating to magazine
sales to retailers and publishers throughout the United States and
Canada.
The Wood Manufacturing group derives revenues from designing,
manufacturing and installing custom wood fixtures primarily for retailers.
COST OF REVENUES
Our cost of revenues for the Magazine Fulfillment group consists of the
costs of magazines purchased for resale less all applicable publisher discounts
and rebates.
Our cost of revenues for the In-Store Services and the Wood Manufacturing
groups includes:
- raw materials consumed in the production of display fixtures,
primarily steel, wood and plastic components;
- production labor; and
- manufacturing overhead.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for each of the operating
groups include:
- non-production labor;
- rent and office overhead;
- insurance;
- professional fees; and
- management information systems.
Expenses associated with corporate finance, human resources, management
information systems and executive offices are included within the Shared
Services group and are not allocated to the other groups.
24
FULFILLMENT FREIGHT
Fulfillment freight consists of our direct costs of distributing magazines
by third-party freight carriers, primarily Federal Express ground service.
Freight rates are driven primarily by the weight of the copies being shipped and
the distance between origination and destination.
Fulfillment freight is not disclosed as a component of cost of revenues,
and, as a result, gross profit and gross profit margins are not comparable to
other companies that include shipping and handling costs in cost of revenues.
Fulfillment freight has increased proportionately as the amount of product
we distribute has increased. We anticipate the continued growth in our Magazine
Fulfillment group will result in an increase in fulfillment freight. Generally,
as pounds shipped increase, the cost per pound charged by third party carriers
decreases. As a result, fulfillment freight as a percent of the Magazine
Fulfillment group's gross revenues should decline slightly in the future.
RELOCATION EXPENSES
During fiscal 2005, the Company incurred $2.5 million of expenses related
to distribution center relocations and a plant conversion. The Company began
expansion into the mainstream retail market which resulted in distribution
fulfillment centers in Milan, OH, San Diego, CA and Kent, WA being moved to
Harrisburg, PA and Carson City, NV.
During fiscal 2004, the Company incurred $1.7 million of expenses related
to relocating its claims submission and fixture billing center, its Corporate
Headquarters, and its Magazine Fulfillment administrative offices to its
facility in Bonita Springs, FL.
25
RESULTS OF OPERATIONS
The following table sets forth, for the periods presented, information
relating to our continuing operations (in thousands):
YEAR ENDED JANUARY 31
------------------------------------------------------------------
2003 2004 2005
------------------- ------------------ --------------------
MARGIN MARGIN MARGIN
$ % $ % $ %
--------- ------ --------- ------ --------- ------
MAGAZINE FULFILLMENT
Revenues...................... $ 189,960 $ 238,471 $ 280,171
Cost of Revenues.............. 145,650 179,460 210,639
Gross Profit.................. 44,310 23.3% 59,011 24.7% 69,532 24.8%
Operating Expenses(1)......... 37,046 44,585 53,030
Operating Income ............. 7,264 3.8% 14,426 6.0% 16,502 5.9%
IN-STORE SERVICES(2)
Revenues...................... $ 61,754 $ 58,601 $ 54,103
Cost of Revenues.............. 35,391 33,931 29,368
Gross Profit.................. 26,363 42.7% 24,670 42.1% 24,735 45.7%
Operating Expenses(1)......... 21,512 8,245 8,777
Operating Income.............. 4,851 7.9% 16,425 28.0% 15,958 29.5%
WOOD MANUFACTURING
Revenues...................... $ 17,477 $ 18,719 $ 22,370
Cost of Revenues.............. 16,390 16,357 18,844
Gross Profit.................. 1,087 6.2% 2,362 12.6% 3,526 15.8%
Operating Expenses(1)......... 1,799 1,373 1,241
Operating Income (Loss)....... (712) (4.1)% 989 5.3% 2,285 10.2%
SHARED SERVICES(2)
Revenues...................... $ - $ - $ -
Cost of Revenues.............. - - -
Gross Profit.................. - - - - - -
Operating Expenses(1)......... - 14,446 16,721
Operating (Loss).............. - - (14,446) - (16,721) -
TOTAL
Revenues...................... $ 269,191 $ 315,791 $ 356,644
Cost of Revenues.............. 197,431 229,748 258,851
Gross Profit.................. 71,760 26.7% 86,043 27.2% 97,793 27.4%
Operating Expenses(1)......... 60,357 68,649 79,769
Operating Income ............. 11,403 4.2% 17,394 5.5% 18,024 5.4%
- ------------
(1) Operating expenses include selling, general and administrative expenses,
fulfillment freight, relocation expenses, loss on sale of land and
building and amortization of intangibles.
(2) Prior to fiscal year 2004 amounts currently reported as Shared Services
were reported as a component of In-Store Services.
26
RESULTS FOR THE FISCAL YEAR ENDED JANUARY 31, 2005 COMPARED TO THE FISCAL
YEAR ENDED JANUARY 31, 2004
Revenues
Overall revenues for the fiscal year ended January 31, 2005 increased
$40.9 million, or 12.3% from the prior year due primarily to an increase in
revenue in our Magazine Fulfillment group as described below.
Our Magazine Fulfillment group's revenues were $280.2 million, an increase
of $41.7 million or 17.5% as compared to the prior fiscal year.
The group's revenues for fiscal year 2005 and 2004 are comprised of the
following components (in thousands):
2005 2004 CHANGE
--------- --------- --------
Domestic distribution......................... $ 238.9 $ 204.6 $ 34.3
Export distribution........................... 38.5 32.0 6.5
Other......................................... 3.8 3.4 0.4
Intra-segment sales........................... (1.0) (1.5) 0.5
--------- --------- --------
Total......................................... $ 280.2 $ 238.5 $ 41.7
========= ========= ========
Domestic distribution consists of the gross amount of magazines (both
domestic and imported titles) distributed to domestic retailers and wholesalers,
less actual returns received, less an estimate of future returns and customer
discounts. The $34.3 million increase in domestic distribution relates primarily
to an $80.0 million increase in gross distribution partially offset by higher
returns and estimated return reserve at year-end. The increase in gross
distribution related both to an increase in copies distributed as well as an
increase in the amount billed per copy to specialty retailers as well as the
expansion of our distribution network to traditional retailers via internal
marketing efforts as well as the acquisition of Empire News, a traditional
wholesaler servicing the western New York and northern Pennsylvania markets.
Gross domestic distribution to our two largest customers increased $36.6
million. Gross distribution to traditional retailers increased from $10.9
million to $43.1 million, an increase of $32.2 million. Estimated sell-through
for the period was lowered from 46.7% to 45.9%. The decreased estimated
sell-through relates primarily to the increase in the percent of our
distribution related to traditional retailers who generally have lower
sell-through percentages than specialty retailers.
Our export distribution began operations in March 2003. Export
distribution increased $6.5 million compared to the prior fiscal year due
primarily to an additional month of distribution in the current fiscal year.
Our In-Store Services group's revenues for fiscal year ended January 31,
2005 were $54.1 million, a decrease of $4.5 million or 7.7% over the prior year.
The group's revenues for the fiscal year ended January 31, 2005 and 2004
are comprised of the following components (in thousands):
2005 2004 CHANGE
-------- -------- ------
Claim filing and information.................. $ 17.3 $ 14.0 $ 3.3
Wire manufacturing............................ 36.8 44.6 (7.8)
-------- -------- ------
Total......................................... $ 54.1 $ 58.6 $ (4.5)
======== ======== ======
Our claim filing revenues are recognized at the time the claim is paid.
The increase in revenues in the fiscal year ended January 31, 2005 relate to the
timing of the cash payments received on the claims. In addition, we acquired
Promag Retail Services, LLC in August 2004 which also contributed to the
increased revenues for the fiscal year ended January 31, 2005. Information
services revenue increased by approximately $0.5 million over the prior year
relating to additional information product contracts being entered into in the
current year.
Our front end wire and services revenues declined due to the cyclical
nature of the industry. Major chains typically purchase new front-end fixtures
every three years; however, the use of the front end fixtures has been extending
beyond this life cycle.
27
Our Wood Manufacturing group's revenues for the fiscal year ended January
31, 2005 were $22.4 million, an increase of approximately $3.7 million or 19.5%
over the prior year. The increase for the fiscal year ended January 31, 2005
relates to an increase in the number of store openings and remodelings performed
by our customers.
Gross Profit
Gross profit for the fiscal year ended January 31, 2005 increased $11.8
million, or 13.7 %, over the prior fiscal year primarily due to an increase in
sales volume in our Magazine Fulfillment group and our Wood Manufacturing Group.
Our Magazine Fulfillment gross profits were $69.5 million, an increase of
$10.5 million or 17.8%, compared to the prior fiscal year. The increase related
primarily to the increased distribution revenue as described above and the
improvement in gross profit margins from 24.7% to 24.8%. The gross profit
margins in our domestic distribution businesses are generally higher than our
export distribution and, as a result, overall gross profit margins improve as
the portion of total revenues is weighted more toward our domestic operations.
In addition, we receive certain supplier rebates on gross distribution and as
estimated sell-through decreases those rebates become a greater portion of the
overall gross profit contribution yielding higher gross profit margins.
Gross profit in our In-Store Services group for the fiscal year period
ended January 31, 2005 increased $0.1 million, or 0.03%, over the prior year.
The increase in gross profit is primarily due to a larger percentage of our
sales occurring in claim filing and information which is a significantly higher
margin business than our front end wire and services.
Gross profit in our Wood Manufacturing group for the fiscal year ended
January 31, 2005 increased $1.2 million, or 49.3%, over the prior year. The
increase relates primarily to operational efficiencies at our manufacturing
facilities.
Selling, General and Administrative Expenses
Selling, general and administrative expenses for the fiscal year ended
January 31, 2005 increased $4.6 million, or 9.1%, over the prior year. Selling,
general, and administrative expenses as a percent of revenues declined from
16.0% to 15.5% in those same periods.
The Magazine Fulfillment group's selling, general, and administrative
expenses were $29.9 million, an increase of $3.3 million, or 12.5% over the
prior fiscal year. As a percentage of sales, selling, general and administrative
expenses have decreased from 11.1% to 10.7% compared to the prior year same
period due to our ability to leverage existing infrastructure over a larger base
of distribution and the consolidation of our distribution centers in Harrisburg,
Pennsylvania and Carson City, Nevada. Overall expenses have increased due to the
increase in our traditional distribution business and the related merchandising
and distribution labor in our distribution centers and the expansion of our
marketing efforts in the United Kingdom.
The selling, general, and administrative expenses of In-Store Services in
the fiscal year ended January 31, 2005 increased $0.2 million, or 2.1%, compared
to the fiscal year ended January 31, 2004. The increase relates to an increase
in general operating expenses offset by a reduction in executive salary expense
in the fiscal year ended January 31, 2005 compared to the fiscal year ended
January 31, 2004.
The selling, general, and administrative expenses of Shared Services for
the fiscal year ended January 31, 2005 increased $1.2 million, or 8.6%, compared
to the fiscal year ended January 31, 2004. The overall increase is primarily due
to Sarbanes-Oxley compliance charges and increased depreciation expense due to
increased capital expenditures.
The Wood Manufacturing group's selling, general, and administrative
expenses in the fiscal year ended January 31, 2005 decreased $0.1 million, or
9.6%, compared to the fiscal year ended January 31, 2004. The decrease was
attributable primarily to a head count reduction.
28
Fulfillment Freight
Fulfillment freight represents the outbound freight costs of domestic
distribution. It consists primarily of payments to third party carriers to
provide delivery service from our distribution centers to our customer's retail
stores.
Our Magazine Fulfillment group's freight expense was $21.1 million, an
increase of $4.7 million or 28.6% compared to the prior fiscal year. Freight
expense as a percentage of gross domestic distribution increased from 3.7% to
4.0%. The increase was primarily attributable to expansion of our fulfillment
business where we receive a per pound fee to ship other distributors product.
Relocation Expenses
During fiscal 2005, the Company incurred $2.5 million of expenses related
to distribution center relocations and a plant conversion. The Company began
expansion into the mainstream retail market which resulted in distribution
fulfillment centers in Milan, OH, San Diego, CA and Kent, WA being moved to
Harrisburg, PA and Carson City, NV.
During fiscal 2004, the Company incurred $1.7 million of expenses related
to relocating its claims submission and fixture billing center, its Corporate
Headquarters, and its Magazine Fulfillment administrative offices to its new
facility in Bonita Springs, FL.
Loss on sale of land and building
For the fiscal year ended January 31, 2005, the Company recognized a
loss on the sale of land and building of approximately $1.1 million for a vacant
property located in Highpoint, NC.
Operating Income
Operating income for the fiscal year ended January 31, 2005 increased $0.6
million or 3.6%, compared to the fiscal year ended January 31, 2004 due to the
factors described above.
Operating profit margins for the fiscal year ended January 31, 2005
decreased from 5.5% to 5.0% as compared to the prior year due to the relocation
costs and loss on sale of land and building discussed above.
Interest Expense
Interest expense includes the interest and fees on our significant debt
instruments and outstanding letters of credit.
Interest expense decreased $1.9 million, or 54%, for the fiscal year ended
January 31, 2005 compared to the fiscal year ended January 31, 2004. This
decrease was due to significantly lower borrowings in the current fiscal year.
The lower borrowing levels are due to the raising of proceeds from the sale of
3.8 million shares of our common stock.
Other Income (Expense)
Other income (expense) consists of items outside of the normal course of
operations. Due to its nature, comparability between periods is not generally
meaningful.
For the fiscal years ended January 31, 2005 and 2004, we recorded charges
of approximately $1.5 million and $0.9 million, respectively, related to the
write off of deferred financing charges as a result of paying off certain debt
instruments, as described below in "Liquidity and Capital Resources."
29
Income Tax Expense
The effective income tax rates on income from continuing operations were
14.6% and 26.6% for the fiscal years ended January 31, 2005 and 2004,
respectively. The difference between the statutory rate and effective tax rates
relates primarily to the realization of a net operating loss carry-forward
acquired with our acquisition of Interlink through the reduction of the deferred
tax valuation allowance in fiscal year 2005 and 2004. Additionally, at January
31, 2005, the Company reassessed the future utilization of such NOLs and
determined that it is more likely than not that the benefit of such NOL will be
realized and a valuation allowance is no longer necessary, accounting for the
difference in the effective tax rate from 2005 to 2004.
RESULTS FOR THE FISCAL YEAR ENDED JANUARY 31, 2004 COMPARED TO THE FISCAL
YEAR ENDED JANUARY 31, 2003
Revenues
Revenues for the fiscal year ended January 31, 2004 increased $46.6
million, or 17.3%, over the prior fiscal year due primarily to an increase in
revenue in our Magazine Fulfillment group.
Our Magazine Fulfillment group's revenues for the fiscal year ended
January 31, 2004 were $238.5 million, an increase of $48.5 million, or 25.5%,
over the prior fiscal year. The group's revenues for the fiscal years ended
January 31, 2004 and 2003 are comprised of the following components (in
millions):
2004 2003 CHANGE
-------- -------- ------
Domestic distribution............................. $ 204.6 $ 188.6 $ 16.0
Export distribution............................... 32.0 - 32.0
Other............................................. 3.4 2.5 0.9
Intra-segment sales............................... (1.5) (1.1) (0.4)
-------- -------- ------
Total............................................. $ 238.5 $ 190.0 $ 48.5
======== ======== ======
Domestic distribution consists of the gross amount of magazines (both
domestic and imported titles) distributed to domestic retailers and wholesalers,
less actual returns received (collectively, "actual net distribution"), less an
estimate of future returns and customer discounts. The $16.0 million increase in
domestic distribution consisted of a $26.3 million increase in actual net
distribution, less a $10.1 million decrease from the impact of the change in the
sales return reserve as compared to the prior year's change, and a $0.2 million
increase in customer discounts. Actual net domestic distribution increased from
$189.8 million to $216.1 million; an increase of $26.3 million or 13.9%. This
increase was driven primarily by the growth of distribution to our two main
customers, which increased from $155.5 million to $173.7 million or $18.2
million. The sales return reserve related to our domestic distribution increased
from $33.1 million to $41.4 million or $8.3 million. Customer discounts
increased from $3.0 million to $3.2 million.
Our export distribution began operation in March 2003. Actual net export
distribution was $52.4 million. At January 31, 2004, the sales return reserve
related to our export distribution was $20.4 million.
Our In-Store Services group's revenues for the fiscal year ended January
31, 2004 were $58.6 million, a decrease of $3.2 million or 5.1% over the prior
fiscal year.
The group's revenues for the fiscal years ended January 31, 2004 and 2003
are comprised of the following components (in millions):
2004 2003 CHANGE
-------- -------- ------
Claim filing and information...................... $ 14.0 $ 14.0 $ -
Wire manufacturing................................ 44.6 47.8 (3.2)
-------- -------- ------
Total............................................. $ 58.6 $ 61.8 $ (3.2)
======== ======== ======
Our wire manufacturing revenues declined due to the cyclical nature of the
industry (major chains purchase new front-end fixtures every three years) and
pricing pressure in our industry.
Our Wood Manufacturing group's revenues for the fiscal year ended January
31, 2004 were $18.7 million, an increase $1.2 million or 7.1% compared to the
prior fiscal year.
30
Gross Profit
Gross profit for the fiscal year ended January 31, 2004 increased $14.3
million, or 19.9%, over the prior fiscal year due primarily to an increase in
gross profit in our Magazine Fulfillment group.
Gross profit margins for the fiscal year ended January 31, 2004 increased
2.2% over the prior fiscal year. Margins improved or (declined) in our Magazine
Fulfillment, In-Store Services, and Wood Manufacturing groups by 1.4%, (0.6)%,
and 6.4%, respectively.
Gross profit in our Magazine Fulfillment group for the fiscal year ended
January 31, 2004 increased $14.7 million, or 33.2%, over the prior fiscal year.
The increase related to both the increase in revenue described above as well as
improving margins. The gross profit margins in our domestic distribution
businesses are generally higher than our export distribution business and, as a
result, gross profit margins improve as the portion of total revenues is
weighted more heavily toward our domestic operations. The margins in our
distribution business also improved as a result of a shift in product mix from
lower margin domestic titles to higher margin imported titles.
Gross profit in our In-Store Services group for the fiscal year ended
January 31, 2004 decreased $1.7 million, or 6.4%, over the prior fiscal year.
The decrease related to both the decrease in revenues described above as well as
declining margins. The decrease in margins is both due to a decrease in pricing
as well as the recent increase in commodity prices particularly steel, which is
a major component of our front-end fixtures.
Gross profit in our Wood Manufacturing group for the fiscal year ended
January 31, 2004 increased $1.3 million, or 117.3%, over the prior fiscal year.
The increase related to both the increase in revenue described above as well as
improving margins. The prior fiscal year results included a significant
inventory write-off related to a lost customer.
Selling, General and Administrative Expenses
Selling, general and administrative expenses for the fiscal year ended
January 31, 2004 increased $6.8 million, or 15.6%, over the prior fiscal year.
Selling, general, and administrative expenses as a percent of revenues decreased
from 16.2% to 16.0% in those same periods.
The Magazine Fulfillment group's selling, general, and administrative
expenses for the fiscal year ended January 31, 2004 increased $4.3 million, or
19.4%, over the prior fiscal year. The inception of our magazine export business
resulted in $2.5 million of the increase.
The combined selling, general and administrative expenses of In-Store
Services and Shared Services for the fiscal year ended January 31, 2004
increased $2.9 million, or 15.0%, over the prior fiscal year. The increase is
attributable to an expanded corporate infrastructure to support our enlarged
scope of operations.
The Wood Manufacturing group's selling, general, and administrative
expenses for the fiscal year ended January 31, 2004 decreased $0.4 million, or
23.7%, over the prior fiscal year. The decrease was attributable to both the
unusually high level of expenses in the fourth quarter of fiscal 2003 as well as
the cost savings attributable to the consolidation of our manufacturing capacity
in Carson City, Nevada into the facility in Albemarle, North Carolina.
Fulfillment Freight
Fulfillment freight expenses for the fiscal year ended January 31, 2004
increased $1.7 million, or 11.5%, over the prior fiscal year. Freight as a
percentage of the Magazine Fulfillment group's revenues decreased from 6.9% to
6.4% due to improvement in the efficiency of our distribution model and an
increase in the number of pounds distributed. Under our existing contract, our
freight rates per pound decrease as the number of pounds shipped increases.
Relocation Expenses
During fiscal 2004, we relocated our magazine distribution back office
from San Diego, California to Bonita Springs, Florida. The total expense
recorded in the period related to this relocation was $1.7 million.
31
During fiscal 2003, we relocated our claim submission and fixture billing
center from High Point, North Carolina to Bonita Springs, Florida. The total
expense recorded in the period related to this relocation was $1.9 million.
Operating Income
Operating income for the fiscal year ended January 31, 2004 increased $6.0
million, or 52.5%, compared to the prior fiscal year due to the factors
described above.
Operating profit margins for the fiscal year ended January 31, 2004
improved to 5.5% from 4.2% in the prior fiscal year. The increase was due
primarily to the improvement in our gross profit margins in our magazine
fulfillment business.
Interest Expense
Interest expense includes the interest and fees on our significant debt
instruments and outstanding letters of credit.
Other Income (Expense)
Other income (expense) consists of items outside of the normal course of
operations. Due to its nature, comparability between periods is not generally
meaningful.
Other expense in the fiscal year ended January 31, 2004 includes a charge
of $0.9 million related to the refinancing of our senior credit facilities.
Other income in the fiscal year ended January 31, 2004 related primarily
to the favorable settlement of an outstanding liability.
Income Tax Expense
The effective income tax rates were 26.6% and 10.3% for the fiscal years
ended January 31, 2004 and 2003, respectively.
The difference between the statutory rate and effective tax rates relates
primarily to the realization of a portion of the net operating loss
carry-forward acquired with our acquisition of Interlink and tax credits
received from the state of Florida related to our relocation.
LIQUIDITY AND CAPITAL RESOURCES
OVERVIEW
Our primary sources of cash include receipts from our customers,
borrowings under our credit facilities and from time to time the proceeds from
the sale of common stock.
Our primary cash requirements for the Magazine Fulfillment group consist
of the cost of magazines and the cost of freight, labor and facility expense
associated with our distribution centers.
Our primary cash requirements for the In-Store Services group consist of
the cost of raw materials, labor, and factory overhead incurred in the
production of front-end displays, the cost of labor incurred in providing our
claiming, design and information services and cash advances funding our Advance
Pay program. Our Advance Pay program allows retailers to accelerate collections
of their rebate claims through payments from us in exchange for the transfer to
us of the right to collect the claim. We then collect the claims when paid by
publishers for our own account.
32
Our primary cash requirements for the Wood Manufacturing group consist of
the cost of raw materials, the cost of labor, and factory overhead incurred in
the manufacturing process.
Our primary cash requirements for the Shared Services group consist of
salaries, professional fees and insurance not allocated to the operating groups.
The following table presents a summary of our significant obligations and
commitments to make future payments under debt obligations and lease agreements
due by fiscal year as of January 31, 2005 (in thousands).
PAYMENTS DUE BY PERIOD
------------------------------------------------
LESS
THAN AFTER
TOTAL 1 YEAR 1-3 YEARS 3-5 YEARS 5 YEARS
--------- -------- --------- --------- --------
Debt obligations......................................... $ 39,769 $ 5,630 $ 10,570 $ 23,569 $ -
Operating leases......................................... 33,052 5,169 7,253 6,451 14,179
--------- -------- --------- --------- --------
Total contractual cash obligations....................... $ 72,821 $.10,799 $ 17,823 $ 30,020 $ 14,179
========= ======== ========= ========= ========
The following table presents a summary of our commercial commitments and
the notional amount expiration by period (in thousands):
NOTIONAL AMOUNT EXPIRATION BY PERIOD
---------------------------------------
LESS
THAN 1 1-3 3-5 AFTER
TOTAL YEAR YEARS YEARS 5 YEARS
-------- -------- ----- ----- -------
Financial standby letters of credit......................... $ 1,800 $ 1,800 $ - $ - $ -
-------- -------- ----- ----- -------
Total commercial commitments................................ $ 1,800 $ 1,800 $ - $ - $ -
======== ======== ===== ===== =======
OPERATING CASH FLOW
Net cash (used in) provided by operating activities was ($11.5) million,
$12.3 million and $20.6 million for the fiscal years ended January 31, 2005,
2004 and 2003, respectively.
Operating cash flows for the fiscal year ended January 31, 2005 were
primarily from net income $12.1 million, plus non-cash charges including
depreciation and amortization of $5.4 million and provisions for losses on
accounts receivable of $3.0 million, a write off of deferred financing costs and
original issue discount of $1.5 million, a loss of the sale of land and building
of $1.1 million, a decrease in inventories of $0.6 million and a decrease in
other current and non-current assets of $0.7 million. These cash providing
activities were offset by an increase in accounts receivable of $10.3 million
and a decrease in accounts payable and accrued expenses of $24.8 million.
The increase in accounts receivable for the fiscal year ended January 31,
2005 was primarily due to an increase in accounts receivable in our Magazine
Fulfillment group of $6.6 million. The increase was due to an overall increase
in distribution levels, especially in the last month of the quarter, more
lenient payment terms offered to a significant customer in exchange for more
favorable pricing, and partially offset by $13.8 million increase in the sales
return reserve from the end of fiscal 2004.
The In-Store Services Group had an increase in accounts receivable of
approximately $2.0 million due primarily due to the seasonal nature of the wire
manufacturing business, which generally has the highest receivable balance in
the third quarter. The fourth quarter is generally our best collection and cash
flow quarter of the year as revenues from the third quarter are collected.
Receivables in our Wood Manufacturing division increased by approximately
$0.2 million, due to additional revenues for the year of approximately $3.7
million.
The decrease in accounts payable and accrued expenses for the fiscal year
ended January 31, 2005 of $24.8 million relates primarily to a $12.5 million
increase of purchase return reserves in our Magazine Fulfillment group.
Operating cash flows for the fiscal year ended January 31, 2004 were
primarily from net income ($10.1 million), plus non-cash charges including
depreciation and amortization ($4.1 million) and provisions for losses on
accounts
33
receivable ($1.8 million), a decrease in accounts receivable ($0.5 million) and
a decrease in other current and non-current assets ($2.0 million). These cash
providing activities were offset by an increase in inventory ($1.3 million), and
a decrease in accounts payable and accrued expenses other current and
non-current liabilities ($5.7 million).
Accounts receivable and accounts payable balances were impacted by the
inception of the magazine export business, which had trade receivable of $14.2
million and trade payables of $10.0 million at January 31, 2004. The magazine
export agreement allowed us to become a leading exporter of domestic titles to
foreign wholesalers and domestic brokers who transport the product overseas. The
fiscal year includes eleven months of operations from this business and only
eight months of cash collections due to standard payment terms of at least 90
days, which is typical in the industry.
Accounts receivable related to our domestic magazine distribution
businesses decreased $2.6 million primarily due to the increase in the sales
return reserve partially offset by the growth in trade receivables as a result
of higher distribution levels. Inventories for this business increased $1.7
million primarily to support higher distribution levels.
Accounts receivable in our front-end fixture manufacturing and claim
filing services decreased $6.7 million due to both better collection procedures
as well as the lower revenue base.
Operating cash flow for the fiscal year ended January 31, 2003 was
primarily from net income ($7.3 million), adding back non-cash charges such as
depreciation and amortization ($3.3 million) and provisions for losses on
accounts receivable ($2.0 million) and a significant decrease in accounts
receivable ($17.6 million). These cash providing activities were offset by a
significant reduction in accounts payable ($9.7 million).
The decrease in accounts receivable relates primarily to a significant
decrease in receivables related to front-end fixture programs, which were at
unusually high levels at January 31, 2002 and subsequently collected in the
first quarter of fiscal 2003.
The decrease in receivables related to front-end fixture programs relates
primarily to the timing of payments by significant participants of cost-shared
front-end fixture programs. Our year-end balance at January 31, 2002 was
inflated by the significantly higher revenue in the third quarter of fiscal 2002
that was, for the most part, collected in the first quarter of fiscal 2003.
Improved cash flow and profits in our Magazine Distribution group allowed
for a significant reduction in accounts payable ($13.0 million of the total
decrease). We believe that this decrease was necessary to bring us within
payment terms with all our publishers, which has significantly improved our
relationship with the publishing community and allowed us to expand our business
with those publishers.
INVESTING CASH FLOW
Net cash used in investing activities was $19.8 million, $9.5 million and
$12.8 million in the fiscal years ended January 31, 2005, 2004 and 2003,
respectively.
For the fiscal year ended January 31, 2005, cash used in investing
activities included capital expenditures of $7.1 million, which in part related
to our expansion of our distribution facilities in Harrisburg, Pennsylvania and
Carson City, Nevada. Our advance pay program generated net cash flow of $4.0
million in the fiscal year ended January 31, 2005. In addition, we collected
$6.8 million from the prior operator of our export distribution business during
2005. The initial advances were made as part of the agreement to collect the
prior operator's receivables and pay outstanding payables so as to create a
seamless transition for both the customers and suppliers. In addition, we
incurred approximately $2.6 million in acquisition costs related to the
acquisition of Alliance Entertainment Corp.
In August 2004, we acquired all customer-based intangibles (i.e., all
market composition, market share and other value) respecting claiming and
information services of PROMAG Retail Services, LLC ("Promag") for approximately
$13.2 million. Of the $13.2 million purchase price, $10.0 million was funded
from a term loan discussed below and $0.75 million in a promissory note payable
over a three year period to Promag. Promag provides claim filing services
related to rebates owed retailers from publishers or their designated agent
throughout the United States and Canada.
34
In September 2004, we acquired substantially all of the assets and
liabilities of Empire State News Corp. ("Empire"), a magazine wholesaler in
northwest New York state, for approximately $5.0 million. The purchase price
consisted of $3.4 million of cash paid and $1.6 million of deferred
consideration in the form of two notes payable ($1.2 million) and deferred
compensation, subject to finalization of working capital adjustments in
accordance with the purchase agreement.
In November 2004, the Company entered into an agreement to terminate the
leases under the magazine import and the magazine export agreements and acquire
all import and export assets, naming rights and other intangibles including a
non-compete by the seller. The purchase price of the import and export
businesses was approximately $14.1 million (after an allowed reduction of the
purchase price for the payments made by the Company under the prior leases
agreements). The purchase price was comprised of $4.2 million paid in cash on
the last business day of November 2004 and additional notes payable in the
principal amount of $7.7 million.
In the fiscal year ended January 31, 2004, cash used in investing
activities related to capital expenditures of $2.1 million, which primarily
related to our relocation to Florida and expansion of our distribution facility
in Harrisburg, Pennsylvania, and $2.4 million of payments related to acquisition
of the customer lists under the import and export agreement. Our advance pay
program generated net cash flow of $1.8 million in the fiscal year ended January
31, 2004. We also advanced to the prior operator of our export distribution
business $6.8 million. The advances were made as part of the agreement to
collect the prior operator's receivables and pay outstanding payables so as to
create a seamless transition for both the customers and suppliers. This balance
had decreased to approximately $3.0 million at March 31, 2004.
For the fiscal year ended January 31, 2003, cash used in investing
activities related to capital expenditures of $4.4 million, which related
primarily to our relocation to Florida, the acquisition of Innovative Metal
Fixtures ($2.0 million of a total purchase price of approximately $2.6 million;
the remaining portion consisting of a note payable to the former owner) and a
payment under a magazine import agreement ($2.0) million related to the domestic
distribution of foreign titles. Our advance pay program used net cash flow of
$4.4 million.
The faster collection cycle for our claim receivables resulted from
providing publishers with the claim information in an electronic format allowing
for quicker processing. As a result of this new process, claims outstanding
related to our Advance Pay program decreased compared to the prior fiscal
year-end, without a significant decrease in either the number or amount of
claims filed.
Our borrowing agreements limit the amount of our capital expenditures in
any fiscal year.
FINANCING CASH FLOW
Outstanding balances on our credit facility fluctuate partially due to the
timing of the retailer rebate claiming process and our Advance Pay program, the
seasonality of our wire manufacturing business, and the payment cycle of the
magazine distribution business. Because the magazine distribution business and
Advance Pay program cash requirement peak at our fiscal quarter ends, the
reported bank debt levels usually are the maximum level outstanding during the
quarter.
Payments under our Advance Pay program generally occur just prior to our
fiscal quarter end. The related claims are not generally collected by us until
90 days after the advance is made. As a result, our funding requirements peak at
the time of the initial advances and decrease over the next 90 days as the cash
is collected on the related claims.
The wire manufacturing business is seasonal because most retailers prefer
initiating new programs before the holiday shopping season begins, which
concentrates revenues in the second and third quarter. Receivables from these
fixture programs are generally collected from all participants within 180 days.
We are usually required to tender payment on the costs of these programs (raw
material and labor) within a shorter period. As a result, our funding
requirements peak in the second and third fiscal quarters when we manufacture
the wire fixtures and decrease significantly in the fourth and first fiscal
quarters as the related receivable are collected and significantly less
manufacturing activity is occurring.
35
Within our magazine distribution business, our significant customers pay
weekly, and we pay our suppliers monthly. As a result, funding requirements peak
at the end of the month when supplier payments are made and decrease over the
course of the next month as our receivables are collected.
Net cash provided by (used in) financing activities was $27.6 million,
($3.4 million) and ($5.2) million in the fiscal years ended January 31, 2005,
2004 and 2003, respectively.
Financing activities in the fiscal year ended January 31, 2005 consisted
of proceeds from the sale of 3.8 million shares of common stock. The proceeds
generated from the issuance of common stock were approximately $40.5 million
(net of underwriting and related expenses). We utilized a portion of these
proceeds to repay the Wells Fargo Foothill original term loan, the Hilco Capital
note payable and the notes payable to former owners. Total payments on notes
payable in the current year was $24.0 million. For the fiscal year ended January
31, 2005, borrowings on the credit facilities totaled $7.6 million and a term
loan in the amount of $10.0 million was issued related to the Promag
transaction. In addition, the cash provided by the activities noted above was
offset by a $12.2 million decrease in checks issued and outstanding at January
31, 2005. Finally, the exercise of employee stock options for the fiscal year
generated approximately $5.9 million.
In the fiscal year ended January 31, 2004, cash used in financing
activities related to our various credit facilities included net repayments
under revolving credit facilities of $27.7 million, payments of notes payable of
$6.0 million and proceeds from the issuance of notes payable of $20.0 million.
The exercise of employee stock options generated $2.8 million in proceeds.
Outstanding checks increased $7.5 million as our new consolidated financing
facility allowed for more efficient cash management.
In the fiscal year ended January 31, 2003, cash used in financing
activities related to our various credit facilities included net repayment under
revolving credit facilities of $7.7 million and repayments of notes payable of
$2.8 million. In addition, we repaid approximately $1.0 million of various notes
outstanding to the prior owners of acquired companies. Outstanding checks
increased $6.6 million relating to the timing of our payments to retailers under
the Advance Pay program. At January 31, 2003, we had completed the filing of the
quarterly rebate claims and had just processed a large number of payments, which
was not the case at the end of 2002.
DEBT
At January 31, 2005, our total debt obligations were $39.8 million,
excluding outstanding letters of credit. Debt consists primarily of our amounts
owed under a revolving credit facility, a term loan with Wells Fargo Foothill
and the notes payable related to the acquisition of magazine import and export
businesses.
On October 30, 2003, we entered into a credit agreement with Wells Fargo
Foothill. The credit agreement enabled us to borrow up to $45.0 million under a
revolving credit facility. The credit agreement was to expire on October 30,
2006 and was secured by all of the assets of the Company. In August 2004, the
Company amended the credit facility with Wells Fargo Foothill. The amended
credit facility provided for a $10 million term note payable that bore interest
at the prime rate of interest plus 2.0% (7.25% at January 31, 2005). In
addition, the Company reduced the $45.0 million revolving credit facility to
$40.0 million however the total credit facility remained at $50.0 million. The
term note was payable over five years installments of $0.25 million for four
quarters then $0.35, $0.50, $0.65 and $0.75 million, respectively, over the
subsequent four quarters.
On February 28, 2005, in conjunction with our merger with Alliance, we
entered into an amended and restated secured financing arrangement with Wells
Fargo Foothill, Inc., as arranger and administrative agent (the "Working Capital
Loan Agent") for each of the lenders that may become a participant in such
arrangement, and their successors and assigns (the "Working Capital Lenders")
pursuant to which the Working Capital Lenders will make revolving loans
("Working Capital Loans") to us and our subsidiaries of up to $250 million
("Advances") and provide for the issuance of letters of credit. The terms and
conditions of the arrangement are governed primarily by the Amended and Restated
Loan Agreement dated February 28, 2005 by and among us, our subsidiaries, and
Wells Fargo (the "Amended and Restated Loan Agreement").
The proceeds of the Working Capital Loans are to be used to (i) finance
transaction expenses incurred in connection with the merger of Source Interlink
and Alliance and the reincorporation of Source Interlink into Delaware, (ii)
repay certain existing indebtedness of Alliance and its subsidiaries, (iii)
repay certain existing
36
indebtedness of Source Interlink to Wells Fargo under our previous credit
facility (including, without limitation, a $10 million term loan) and (iv) for
working capital and general corporate purposes, including the financing of
acquisitions.
Outstanding Advances bear interest at a variable annual rate equal to the
prime rate announced by Wells Fargo Bank, National Association's San Francisco
office, plus a margin of between 0% and 1.00% based upon a ratio of the
Registrant's EBITDA to interest expense ("Interest Coverage Ratio"). We also
have the option of selecting up to five traunches of at least $1 million each to
bear interest at LIBOR plus a margin of between 2.00% and 3.00% based upon our
Interest Coverage Ratio. To secure repayment of the Working Capital Loans and
other obligations of ours to the Working Capital Lenders, we and our
subsidiaries granted a security interest in all of our personal property
assets to the Working Capital Loan Agent, for the benefit of the Working Capital
Lenders. The Working Capital Loans mature on October 31, 2010.
The commitment of the Working Capital Lenders to make Advances is subject
to the existence of sufficient eligible assets to support such Advances under a
specified borrowing base formula and compliance with, among other things,
certain financial covenants. Under the Amended and Restated Loan Agreement, we
are required to maintain a specified minimum level of EBITDA and compliance with
specified fixed charge coverage and debt to EBITDA ratios. In addition, we are
prohibited, without consent from the Working Capital Lenders, from:
(i) incurring additional indebtedness or liens on our personal
property assets;
(ii) engaging in any merger, consolidation, acquisition or
disposition of assets or other fundamental corporate change;
(iii) permitting a change of control of us;
(iv) paying any dividends or making any other distribution on
capital stock or other payments in connection with the purchase,
redemption, retirement or acquisition of capital stock;
(v) changing our fiscal year or methods of accounting; and
(vi) making capital expenditures in excess of $19.3 million during
any fiscal year.
Our borrowing base is calculated in part on the amount of eligible VHS,
CD, DVD, video game and related inventory. Such inventory is encumbered by liens
in favor of certain of our vendors, which liens must be subordinated to the
prior lien of the Working Capital Loan Agent. Failure to obtain such
subordination within 30 days after closing will result in such inventory being
ineligible under the borrowing base. Failure to obtain such subordination within
60 days after closing will result in an event of default under the Amended and
Restated Loan Agreement. Additional events of default under the Amended and
Restated Loan Agreement include, among others:
(i) failure to pay our obligations to the Working Capital Lenders or
to otherwise observe its covenants under the Amended and Restated
Loan Agreement and other loan documents,
(ii) any of our subsidiaries becomes insolvent or bankrupt or has
any material portion of its assets seized or encumbered, and
(iii) a material breach or default under any of the Registrant's
material contracts, including contracts for indebtedness.
The balance on the credit facility at January 31, 2005 was $19.3 million.
The balance on the amended and restated credit facility at March 31, 2005 was
$26.3 million and availability was approximately $158.5 million.
On October 30, 2003, we entered into a credit agreement with Hilco
Capital. The note payable had a face value of $15.0 million and was recorded net
of the original issuance discount related to the fair value of warrants issued
concurrently with the note. The note payable bore interest at a rate equal to
the greater of the prime rate (4.75% at October 30, 2004) plus 7.75% or 12% and
deferred interest of 2% due at the termination of the agreement on October 30,
2006. The term loan was paid in full during the quarter ended October 31, 2004.
37
In connection with our acquisition of the magazine import and export
businesses leased by us since May 2002 and March 2003, respectively, we agreed
to make thirteen quarterly principal payments of approximately $0.7 million
beginning in January 2004 and a payment of $1.0 million is payable in May 2005.
The balance outstanding under these notes payable at January 31, 2005 was $9.9
million.
In connection with the acquisition of the assets of Empire, we issued
notes payable totaling $1.2 million to Empire and one of the former owners of
Empire. The notes payable bear interest at the lowest rate per annum allowable
under Section 1274 of the Internal Revenue Code, which was 2.35% as of January
31, 2005.
OFF-BALANCE SHEET ARRANGEMENTS
We do not engage in transactions or arrangements with unconsolidated or
other special purpose entities.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's Discussion and Analysis of Financial Condition and Results of
Operations is based on our 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, revenues and expenses, and related disclosure of contingent
liabilities. Management bases its estimates on historical experience and on
various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Senior management has discussed the development, selection and
disclosure of these estimates with the audit committee of the board. Actual
results may differ from these estimates under different assumptions and
conditions.
Management believes the following critical accounting policies affect its
more significant judgments and estimates used in the preparation of its
consolidated financial statements.
Revenue Recognition
We record a reduction in revenue for estimated magazine sales returns and
a reduction in cost of sales for estimated magazine purchase returns. Estimated
sales returns are based on historical sales returns and daily point-of-
38
sale data from significant customers. The purchase return estimate is calculated
from the sales return reserve based on historical gross profit. If the
historical data we use to calculate these estimates does not properly reflect
future results, revenue and/or cost of sales may be misstated.
Allowance for Doubtful Accounts
We provide for potential uncollectible accounts receivable based on
customer-specific information and historical collection experience. If market
conditions decline, actual collection experience may not meet expectations and
may result in increased bad debt expenses.
Taxes on Earnings
The carrying value of our net deferred tax assets assumes that we will be
able to generate sufficient future taxable income in certain tax jurisdictions,
based on estimates and assumptions. If these estimates and assumptions change in
the future, we may be required to increase or decrease valuation allowances
against its deferred tax assets resulting in additional income tax expenses or
benefits.
Goodwill
Goodwill represents the excess of cost over the fair value of net assets
acquired in connection with business acquisitions. In accordance with SFAS 142,
goodwill and other intangible assets is tested for impairment at the reporting
unit level, which is defined as an operating segment or a component of an
operating segment that constitutes a business for which financial information is
available and is regularly reviewed by management. Management has determined
that the Company's reporting units are the same as its operating segments for
the purpose of allocating goodwill and the subsequent testing of goodwill for
impairment. Goodwill relates primarily to the In-Store Services segment, which
consists of acquired rebate claim filing and wire manufacturing operations. The
annual impairment review was completed in the first fiscal quarter of 2005, 2004
and 2003 and no impairment charge was necessary. The Company assesses goodwill
for impairment at least annually in the absence of an indicator of possible
impairment and immediately upon an indicator of possible impairment. Fair value
of the operating unit is determined based on a combination of discounted cash
flows and publicly traded company multiples and acquisition multiples of
comparable businesses. For goodwill valuation purposes only, the fair value of
the operating segment is allocated to the assets and liabilities of the
operating segment to arrive at an implied fair value of goodwill, based upon
known facts and circumstances as if the acquisition occurred currently. The
difference between the carrying value and the estimated fair value of the
goodwill would be recognized as an impairment loss.
Impairment of Long-Lived Assets
The Company records impairment losses on long-lived assets used in
operations when events and circumstances indicate that the assets might be
impaired and the undiscounted cash flows estimated to be generated by those
assets are less than the carrying amount of those items. Our cash flow
estimates are based on historical results adjusted to reflect our best estimate
of future market and operating conditions. The net carrying value of assets not
recoverable is reduced to fair value. Our estimates of fair value represent our
best estimate based on industry trends and reference to market rates and
transactions.
RECENT ACCOUNTING PRONOUNCEMENTS
On December 15, 2004, the FASB issued a revision of the standard entitled
SFAS No. 123(R), Share Based Payment. Publicly traded companies must apply this
standard as of the beginning of the first annual period that begins after
December 15, 2005. This statement applies to all awards granted after the
required effective date and to awards modified, repurchased, or cancelled after
that date. The cumulative effect of initially applying this Statement, if any,
is recognized as of the required effective date. The company has not completed
its evaluation of the impact of adopting FASB 123R on its consolidated financial
statements, but anticipates that more compensation costs will be recorded in the
future if the use of options for employees and director compensation continues
as in the past. The revised standard will be effective for the Company beginning
in fiscal year 2007. Under the revised standard the Company will be required to
recognize compensation expense on any unvested portion of grants not previously
accounted for under the fair-value-based method.
39
In November 2004, the FASB issued SFAS No. 151, Inventory Costs - an
amendment of ARB no. 43, Chapter 4. This statement amends the guidance in ARB
No. 43, Chapter 4, Inventory Pricing, to clarify the accounting for abnormal
amounts of idle facility expense, freight, handling costs and wasted material
(spoilage). It is effective for fiscal years beginning after June 15, 2004 and
is not expected to have a material impact on the Company.
In December 2004, the FASB issued FSP 109-1, Application of FASB Statement
No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified
Production Activities Provided by the American Jobs Creation Act of 2004. The
FSP states that the impact of this deduction should be accounted for as a
special deduction rather than a rate reduction. It was effective immediately and
has no impact on the Company's 2005 consolidated financial statements. The
Company is currently reviewing its options related to the deduction and is
currently unable to determine whether it may have a material impact in the
future.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Our primary market risks include fluctuations in interest rates and
exchange rate variability.
Our debt primarily relates to credit facilities with Wells Fargo Foothill.
See " -- Liquidity and Capital Resources -- Debt"
The revolving credit facility with Wells Fargo Foothill had an outstanding
principal balance of approximately $19.3 million at January 31, 2005. Interest
on the outstanding balance is charged based on a variable interest rate related
to the prime rate (5.25% at January 31, 2005) plus a margin specified in the
credit agreement based on an availability calculation (0.0% at January 31,
2005).
The amended credit facility provides for a $10.0 million term note payable
that bears interest at the prime rate plus 2% (7.25% at January 31, 2005). The
term note is payable over five years in installments of $0.25 million over four
quarters beginning January 31, 2005 then the quarterly installments increase to
$0.35, $0.50, $0.65 and $0.75 million, respectively, over the subsequent four
years.
The original term note payable with Wells Fargo Foothill was paid in full
in March 2004.
The note payable with Hilco Capital was repaid in full during the quarter
ended October 31, 2004.
As a result of the above, our primary market risks relate to fluctuations
in interest rates.
We do not perform any interest rate hedging activities related to these
two facilities.
In connection with the SunTrust Mortgage discussed above, Alliance entered
into interest rate swap and cap agreements to manage the interest rate risk
exposures of its variable-rate debt portfolio. These instruments are not
designated as hedges, and, accordingly, are recorded at fair value as an asset
or liability in the consolidated balance sheets and interest income/expense in
the consolidated statements of income.
40
Additionally, Alliance has exposure to foreign currency fluctuation
through export sales to international accounts. A significant change in the
relative strength of the dollar to foreign currencies could result in a negative
impact on Alliance's results of operations. Alliance does not conduct any
hedging activities related to foreign currency.
We have exposure to foreign currency fluctuations through our operations
in Canada. These operations accounted for approximately $6.6 million, which
represented 1.8% of our revenues for the year ended January 31, 2005. We
generally pay the operating expenses related to these revenues in the
corresponding local currency. We will be subject to any risk for exchange rate
fluctuations between such local currency and the dollar.
Additionally, we have exposure to foreign currency fluctuation through our
exporting of foreign magazines and the purchased of foreign magazine for
domestic distribution.
Revenues derived from the export of foreign titles (or sale to domestic
brokers who facilitate the export) totaled $38.5 million for the fiscal year or
10.8% of total revenues. For the most part, our export revenues are denominated
in dollars and the foreign wholesaler is subject to foreign currency risks. We
have the availability to control foreign currency risk via increasing or
decreasing the local cover price paid in the foreign markets. There is a risk
that a substantial increase in local cover price due to a decline in the local
currency relative to the dollar could decrease demand for these magazines at
retail and negatively impact our results of operations.
Domestic distribution (gross) of imported titles totaled approximately
$94.3 million (of a total $525.2 million or 17.9%). Foreign publications are
purchased in both dollars and the local currency of the foreign publisher,
primarily Euros and pound sterling. In the instances where we buy in the foreign
currency, we generally have the ability to set the domestic cover price, which
allows us to control the foreign currency risk. Foreign titles generally have
significantly higher cover prices then comparable domestic titles, are
considered somewhat of a luxury item, are sold only at select retail locations,
and sales do not appear to be highly impacted by cover price increases. However,
a significant negative change in the relative strength of the dollar to these
foreign currencies could result in higher domestic cover prices and result in
lower sales of these titles at retail, which would negatively impact our results
of operations.
We do not conduct any significant hedging activities related to foreign
currency.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements are included herein as a separate section
of this report which begins on page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
ITEM 9A. CONTROLS AND PROCEDURES.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Our management is responsible for establishing and maintaining adequate
internal control over our financial reporting, as such term is defined in
Exchange Act Rule 13a-15(f). Under the supervision and with the participation of
management, including our chief executive officer and chief financial officer,
we conducted an evaluation of the effectiveness of our internal control over
financial reporting based on the framework in Internal Control-Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO). Based on this evaluation, our management concluded that our
internal control over financial reporting was effective as of January 31, 2005.
Management's evaluation did not include assessing the effectiveness of
internal control over financial reporting at Alliance Entertainment Corp., which
was acquired on February 28, 2005.
41
Our management's assessment of the effectiveness of our internal control
over financial reporting as of January 31, 2005 has been audited by BDO Seidman
LLP, an independent registered public accounting firm which also audited the
Company's consolidated financial statements included in this Annual Report on
Form 10-K. BDO Seidman LLP's attestation report on management's assessment of
the Company's internal control over financial reporting is included below.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON
INTERNAL CONTROL OVER FINANCIAL REPORTING
Board of Directors
Source Interlink Companies, Inc.
Bonita Springs, Florida
We have audited management's assessment, included in the accompanying
Management's Report, that Source Interlink Companies, Inc. maintained effective
internal control over financial reporting as of January 31, 2005, based on
criteria established in Internal Control-Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (the COSO
criteria). The Company's management is responsible for maintaining effective
internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility
is to express an opinion on management's assessment and an opinion on the
effectiveness of the Company's internal control over financial reporting based
on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating management's assessment, testing
and evaluating the design and operating effectiveness of internal control, and
performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control
over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately
and fairly reflect the transactions and dispositions of the assets of the
company; (2) provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in accordance with
generally accepted accounting principles, and that receipts and expenditures
of the company are being made only in accordance with authorizations of
management and directors of the company; and (3) provide reasonable assurance
regarding prevention or timely detection of unauthorized acquisition, use, or
disposition of the company's assets that could have a material effect on the
financial statements.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that the Company maintained effective
internal control over financial reporting as of January 31, 2005, is fairly
stated, in all material respects, based on the COSO criteria. Also in our
opinion, the Company maintained, in all material respects, effective internal
control over financial reporting as of January 31, 2005, based on the COSO
criteria.
We have also audited, in accordance with the standards of the Public Company
Accounting Standards Board (United States), the consolidated balance sheet of
Source Interlink Companies, Inc. as of January 31, 2005 and 2004, and the
related consolidated statements of income, stockholders' equity and cash flows
for each of the three years in the period then ended and our report dated April
8, 2005 expressed an unqualified opinion on those consolidated financial
statements.
Chicago, Illinois
/s/ BDO Seidman, LLP
April 8, 2005
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
There was no change in our internal control over financial reporting that
occurred during the quarter ended January 31, 2005 that has materially affected,
or is reasonably likely to materially affect, our internal control over
financial reporting.
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
We conducted an evaluation of the effectiveness of the design and
operation of our disclosure controls and procedures as of the end of the period
covered by this Annual Report on Form 10-K. The controls evaluation was done
under the supervision and with the participation of management, including our
chief executive officer and chief financial officer.
Based on this evaluation, our chief executive officer and our chief
financial officer have concluded that, subject to the limitations noted below,
as of the end of the period covered by this Annual Report on Form 10-K, our
disclosure controls and procedures were effective to ensure that information we
are required to disclose in reports that we file or submit under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within the
time periods specified in Securities and Exchange Commission rules and forms.
Attached as exhibits to this annual report are certifications of the chief
executive officer and the chief financial officer, which are required in
accordance with Rule 13a-14 of the Securities Exchange Act of 1934. This
"Controls and Procedures" section includes the information concerning the
controls evaluation referred to in the certifications, and it should be read in
conjunction with the certifications for a more complete understanding of the
topics presented.
SCOPE OF THE EVALUATION
The evaluation of our disclosure controls and procedures included a review
of the controls' objectives and design, the company's implementation of the
controls and the effect of the controls on the information generated for use in
this annual report. In the course of the controls evaluation, we sought to
identify data errors, control problems or acts of fraud and confirm that
appropriate corrective action, including process improvements, were being
undertaken. This type of evaluation is performed on a quarterly basis so that
the conclusions of management, including the Chief Executive Officer and Chief
Financial Officer, concerning the effectiveness of the controls can be reported
in our quarterly reports on Form 10-Q and to supplement our disclosures made in
our Annual Report on Form 10-K. Many of the components of our disclosure
controls and procedures are also evaluated on an ongoing basis by personnel in
our finance department, as well as our independent auditors who evaluate them in
connection with determining their auditing procedures related to their report on
our annual financial statements and not to provide assurance on our controls.
The overall goals of these various evaluation activities are to monitor our
disclosure controls and procedures, and to modify them as necessary.
Among other matters, we also considered whether our evaluation identified
any "significant deficiencies" or "material weaknesses" in our internal control
over financial reporting, and whether the company had identified any acts of
fraud involving personnel with a significant role in our internal control over
financial reporting. We evaluated these matters using the definitions for these
terms found in professional auditing literature. We also sought to address other
controls matters in the controls evaluation, and in each case if a problem was
identified, we considered what revision, improvement and/or correction to make
in accordance with our ongoing procedures.
INHERENT LIMITATIONS ON EFFECTIVENESS OF CONTROLS
The company's management, including the chief executive officer and chief
financial officer, does not expect that our disclosure controls or our internal
control over financial reporting will prevent all error and all fraud. A
42
control system, no matter how well designed and operated, can provide only
reasonable, not absolute, assurance that the control system's objectives will be
met. Further, the design of a control system must reflect the fact that there
are resource constraints, and the benefits of controls must be considered
relative to their costs. Because of the inherent limitations in all control
systems, no evaluation of controls can provide absolute assurance that all
control issues and instances of fraud, if any, within the company have been
detected. These inherent limitations include the realities that judgments in
decision-making can be faulty and that breakdowns can occur because of simple
error or mistake. Controls can also be circumvented by the individual acts of
some persons, by collusion of two or more people, or by management override of
the controls. The design of any system of controls is based in part on certain
assumptions about the likelihood of future events, and there can be no assurance
that any design will succeed in achieving its stated goals under all potential
future conditions. Over time, controls may become inadequate because of changes
in conditions or deterioration in the degree of compliance with policies or
procedures. Because of the inherent limitations in a cost-effective control
system, misstatements due to error or fraud may occur and not be detected.
ITEM 9B. OTHER INFORMATION.
Not applicable
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required by Item 10 with respect to our directors and executive
officers is incorporated by reference from the information under the captions
"Election of Directors", "Executive Officers", "Committees of the Board of
Directors," "Section 16(a) Beneficial Ownership Reporting Compliance," and "Code
of Ethics", contained in the Company's definitive proxy statement in connection
with the solicitation of proxies for the Company's 2005 Annual Meeting of
Stockholders to be held on July 12, 2005 (the "Proxy Statement").
ITEM 11. EXECUTIVE COMPENSATION.
The information required by Item 11 with respect to the compensation of our
chief executive officer and the four other most highly compensated executive
officers is incorporated by reference from the information under the caption
"Compensation of Executive Officers" contained in the Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.
The information required by Item 12 with respect to the security ownership of
our management and significant stockholders is incorporated by reference from
the information under the caption "Security Ownership of Directors, Executive
Officers and Principal Stockholders" and "Securities Authorized for Issuance
under Equity Compensation Plans" contained in the Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by Item 13 with respect to certain relationships and
transactions is incorporated by reference from the information under the caption
"Certain Business Relationships and Transactions" contained in the Proxy
Statement.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.
The information required by Item 14 with respect to fees billed for services
rendered by our principal accountant is incorporated by reference from the
information under the caption "Fees Paid to Independent Auditors" contained in
the Proxy Statement.
43
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
(a) 1. Financial Statements:
Report of Independent Registered Public Accounting Firm
Consolidated balance sheets - January 31, 2005 and 2004
Consolidated statements of income - years ended January 31, 2005,
2004 and 2003
Consolidated statements of stockholders' equity - years ended January
31,2005, 2004 and 2003
Consolidated statements of cash flows - years ended January 31, 2005,
2004 and 2003
Notes to consolidated financial statements
2. Financial statement schedules. The following consolidated financial
statement schedule of Source Interlink Companies, Inc. and subsidiaries
is included herein:
Report of Independent Registered Public Accounting Firm S-1
Schedule II - Valuation and qualifying accounts S-2
All other schedules for which provision is made in the applicable
accounting regulations of the Securities and Exchange Commission are
not required under the related instructions or are inapplicable, and
therefore have been omitted.
3. Exhibits.
See Exhibit Index.
44
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized, on April
18, 2005.
SOURCE INTERLINK COMPANIES, INC.
(registrant)
/s/ Marc Fierman
--------------------------------
Marc Fierman
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this report has been signed below by the following persons on behalf of
the registrant and in the capacities indicated on April 18, 2005.
SIGNATURE TITLE
/s/ S. Leslie Flegel Chairman, Chief Executive
------------------------ Officer and Director (principal
S. Leslie Flegel executive officer)
/s/ James R. Gillis President, Chief Operating
------------------------ Officer and Director
James R. Gillis
/s/ Marc Fierman Chief Financial Officer
------------------------ (principal financial and
Marc Fierman accounting officer)
/s/ A. Clinton Allen Director
------------------------
A. Clinton Allen
/s/ Gray Davis Director
------------------------
Gray Davis
/s/ Michael R. Duckworth Director
------------------------
Michael R. Duckworth
/s/ Ariel Z. Emanuel Director
------------------------
Ariel Z. Emanuel
/s/ David R. Jessick Director
------------------------
David R. Jessick
/s/ Aron S. Katzman Director
------------------------
Aron S. Katzman
/s/ Allan R. Lyons Director
------------------------
Allan R. Lyons
/s/ Gregory Mays Director
------------------------
Gregory Mays
/s/ George A. Schrug Director
------------------------
George A. Schrug
45
SOURCE INTERLINK COMPANIES AND SUBSIDIARIES
EXHIBIT INDEX
Exhibit
Number Description
- ------- -------------------------------------------------------------------------
2.1 Agreement and Plan of Merger, dated November 18, 2004, by and among Source
Interlink Companies, Inc., Alliance Entertainment Corp. and Alligator
Acquisition, LLC , incorporated by reference to Current Report on Form
8-K, as filed with the SEC on November 24, 2004 (File No. 001-13437)
2.2 Agreement and Plan of Merger dated February 28, 2005, between Source
Interlink Companies, Inc., a Missouri corporation and Source Interlink
Companies, Inc., a Delaware corporation, incorporated by reference to
Current Report on Form 8-K, as filed with the SEC on March 4, 2005 (File
No. 001-13437)
3.9 Certificate of Incorporation of Source Interlink Companies, Inc., a
Delaware corporation, incorporated by reference to Current Report on Form
8-K, as filed with the SEC on March 4, 2005 (File No. 001-13437)
3.10 Amended and Restated Bylaws of Source Interlink Companies, Inc., a
Delaware corporation, incorporated by reference to Current Report on Form
8-K, as filed with the SEC on March 4, 2005 (File No. 001-13437)
4.1 Form of Common Stock Certificate of Source Interlink Companies, Inc., a
Delaware corporation, incorporated by reference to Current Report on Form
8-K, as filed with the SEC on March 4, 2005 (File No. 001-13437)
4.2 Form of Warrant issued pursuant to a Loan Agreement dated as of October
30, 2003, by and between Source Interlink Companies, Inc., its
subsidiaries and Hilco Capital, LP, as agent, incorporated by reference to
Current Report on Form 8-K, as filed with the SEC on November 5, 2003.
4.3 Form of Warrant Agreement issued pursuant to a Loan Agreement dated as of
October 30, 2003, by and between Source Interlink Companies, Inc., its
subsidiaries and Hilco Capital, LP, as agent, as amended and restated,
incorporated by reference to Registration Statement on Form S-3, as filed
with the SEC on August 30, 2004 (File No. 333-118655).
4.4 Warrantholders Rights Agreement dated as of October 30, 2003 by and
between Source Interlink Companies, Inc. and Hilco Capital LP,
incorporated by reference to Current Report on Form 8-K, as filed with the
SEC on November 5, 2003 (File No. 001-13437)
4.5 Stockholder's Agreement dated February 28, 2005, between the Registrant
and AEC Associates, LLC, incorporated by reference to Current Report on
Form 8-K, as filed with the SEC on March 4, 2005 (File No. 001-13437)
10.3** The Source Information Management Company Amended and Restated 1995
Incentive Stock Option Plan, incorporated by reference to Annual Report on
Form 10-K, as filed with the SEC on May 1, 2001 (File No. 001-13437)
10.6** Employment Agreement dated February 28, 2005 between the Registrant and
James R. Gillis, incorporated by reference to Current Report on Form 8-K,
as filed with the SEC on March 4, 2005 (File No. 001-13437)
10.20** The Source Information Management Company Amended and Restated 1998
Omnibus Plan, incorporated by reference to Annual Report on Form 10-K, as
filed with the SEC on May 1, 2001 (File No. 001-13437)
10.21** Employment Agreement dated February 28, 2005 between the Registrant and
S. Leslie Flegel, incorporated by reference to Current Report on Form 8-K
,as filed with the SEC on March 4, 2005 (File No. 001-13437)
10.22** Employment Agreement dated February 28, 2005 between the Registrant and
Jason S. Flegel, incorporated by reference to Current Report on Form 8-K,
as filed with the SEC on March 4, 2005 (File No. 001-13437)
10.28 Standard Lease Agreement between SINV II, LLC as Landlord and Source-Huck
Store Fixture Company as Tenant dated October 31, 2001, incorporated by
reference to Annual Report on Form
46
10-K, as filed with the SEC on May 16, 2002 (File No. 001-13437)
10.29 Standard Lease Agreement between SINV, LLC as Landlord and Source-Huck
Store Fixture Company as Tenant dated October 31, 2001, incorporated by
reference to Annual Report on Form 10-K, as filed with the SEC on May 16,
2002 (File No. 001-13437)
10.31 Lease Agreement by and between Riverview Associates Limited Partnership
and Source Interlink Companies, Inc. dated August 9, 2001, incorporated by
reference to Annual Report on Form 10-K, as filed with the SEC on May 16,
2002 (File No. 001-13437
10.31.1 Lease Amendment by and between Riverview Associates Limited Partnership
and Source Interlink Companies, Inc. dated August 27, 2003, incorporated
by reference to Quarterly Report on Form 10-Q, as filed with the SEC on
September 15, 2003 (File No. 001-13437).
10.32 Industrial Lease between Broadway Properties LTD and Innovative Metal
Fixtures, Inc. dated for reference June 1, 2001, and Assignment and
Assumption Agreement between Innovative Metal Fixtures, Inc., Aaron Wire &
Metal Products LTD and Broadway Properties LTD dated May 3, 2002,
incorporated by reference to Annual Report on Form 10-K, as filed with the
SEC on May 1, 2003 (File No. 001-13437)
10.33 Net Lease between Conewago Contractors, Inc. and Pennsylvania
International Distribution Services, Inc. dated as of May 1, 2000,
incorporated by reference to Annual Report on Form 10-K, as filed with the
SEC on May 1, 2003 (File No. 001-13437)
10.33.1 First Amendment to Net Lease between Conewago Contractors, Inc. and
International Periodical Distributors, Inc. effective September 1, 2003,
incorporated by reference to Quarterly Report on Form 10-Q, as filed with
the SEC on December 15, 2003 (File No. 001-13437)
10.33.2 Second Amendment to Net Lease between Conewago Contractors, Inc. and
International Periodical Distributors, Inc. effective December 1, 2004,
incorporated by reference to Quarterly Report on Form 10-Q, as filed with
the SEC on December 10, 2004 (File No. 001-13437)
10.34 Lease Agreement between Regal Business Center, Inc and Publisher
Distribution Services, Inc. dated as of September 1, 1998, as amended by
First Modification and Ratification of Lease Agreement dated as of October
__, 1998 and Second Modification and Ratification of Lease Agreement dated
as of October __, 2001 (dates omitted in original), incorporated by
reference to Annual Report on Form 10-K, as filed with the SEC on May 1,
2003 (File No. 001-13437)
10.36 Commercial Lease Agreement between NCSC Properties LLC and Huck Store
Fixture Company of North Carolina dated July 1, 2002, incorporated by
reference to Annual Report on Form 10-K, as filed with the SEC on May 1,
2003 (File No. 001-13437)
10.37 Agreement between Louis Nathan Wank, Irving Wank, Murray Wank, Sylvia
Goshen, Anna Godel, Sylvia Thorne and/or Wank Brothers and Brand
Manufacturing Corp. dated June 1, 1989, as amended by Extension of Lease
dated October 22, 1999, incorporated by reference to Annual Report on Form
10-K, as filed with the SEC on May 1, 2003 (File No. 001-13437)
10.38 Agreement between Louis Nathan Wank, Irving Wank, Murray Wank, Sylvia
Goshen, Steven Godel, Sylvia Thorne and/or Wank Brothers and Brand
Manufacturing Corporation dated November 1, 1995, as amended by Extension
of Lease dated October 22, 1999, incorporated by reference to Annual
Report on Form 10-K, as filed with the SEC on May 1, 2003 (File No.
001-13437)
10.39 Agreement between Louis Nathan Wank, Irving Wank, Murray Wank, Sylvia
Goshen, Anna Godel, Sylvia Thorne and/or Wank Brothers and Brand
Manufacturing Corp. dated September 1, 1984, as amended by Extension of
Lease dated October 22, 1999, incorporated by reference to Annual Report
on Form 10-K, as filed with the SEC on May 1, 2003 (File No. 001-13437)
10.40 Agreement of Lease dated as of October 24, 2000 by and between Joseph P.
Day Realty Corp., as agent for owner Ron Bet 40th Street LLC, and Brand
Manufacturing Corp., incorporated by reference to Quarterly Report on Form
10-Q, as filed with the SEC on June 16, 2003 (File No. 001-13437)
10.41** Employment Agreement dated February 28, 2005 between the Registrant and
Marc Fierman, incorporated by reference to Current Report on Form 8-K, as
filed with the SEC on March 4, 2005 (File No. 001-13437)
10.44 Amended and Restated Loan Agreement dated February 28, 2005 by and among
the Registrant, its subsidiaries, and Wells Fargo Foothill, Inc., as
arranger and administrative agent, incorporated by reference to Current
Report on Form 8-K, as filed with the SEC on March 4, 2005 (File No.
001-
47
13437)
10.46 Form of Source Interlink Voting Agreement, dated November 18, 2004,
between Source Interlink Companies, Inc., Alliance Entertainment Corp. and
certain stockholders of Source Interlink, incorporated by reference to
Current Report on Form 8-K, as filed with the SEC on November 24, 2004
(File No. 001-13437)
10.48+ Retail Magazine Supply Agreement between Barnes & Noble, Inc. and
International Periodical Distributors, Inc. dated as of August 6, 2004,
incorporated by reference to Quarterly Report on Form 10-Q, as filed with
the SEC on December 10, 2004 (File No. 001-13437)
10.49** Employment Agreement dated February 28, 2005 between the Registrant and
Alan Tuchman, incorporated by reference to Current Report on Form 8-K, as
filed with the SEC on March 4, 2005 (File No. 001-13437)
10.50** The 1999 Equity Participation Plan of Alliance Entertainment Corp.,
incorporated by reference to Exhibit 10.2 to Amendment No. 1 to
Registration Statement on Form S-4, as filed with the SEC on January 18,
2005 (File No. 333-121656)
10.51** The 1999 Employee Equity Participation and Incentive Plan of Alliance
Entertainment Corp., incorporated by reference to Exhibit 10.3 to
Amendment No. 1 to Registration Statement on Form S-4, as filed with the
SEC on January 18, 2005 (File No. 333-121656)
10.52** Amended and Restated Digital On-Demand, Inc. 1998 Executive Stock
Incentive Plan, incorporated by reference to Exhibit 10.4 to Amendment No.
1 to Registration Statement on Form S-4, as filed with the SEC on January
18, 2005 (File No. 333-121656)
10.53** Amended and Restated Digital On-Demand, Inc. 1998 General Stock
Incentive Plan, incorporated by reference to Exhibit 10.5 to Amendment No.
1 to Registration Statement on Form S-4, as filed with the SEC on January
18, 2005 (File No. 333-121656)
10.54 Multi-Tenant Industrial Triple Net Lease, dated as of September 5, 2003,
between Catellus Development Corporation and AEC One Stop Group, Inc.,
incorporated by reference to Exhibit 10.6 to Amendment No. 1 to
Registration Statement on Form S-4, as filed with the SEC on January 18,
2005 (File No. 333-121656)
10.55** Source Interlink Companies, Inc. Supplemental Executive Retirement Plan,
effective as of March 1, 2005, incorporated by reference to Current Report
on Form 8-K, as filed with the SEC on March 4, 2005 (File No. 001-13437)
10.56** Source Interlink Companies, Inc. Challenge Grant Program, incorporated
by reference to Current Report on Form 8-K, as filed with the SEC on March
4, 2005 (File No. 001-13437)
10.57** Executive Participation Agreement dated February 28, 2005 between the
Registrant and James R. Gillis, incorporated by reference to Current
Report on Form 8-K, as filed with the SEC on March 4, 2005 (File No.
001-13437)
10.58** Form of Executive Participation Agreement, incorporated by reference to
Current Report on Form 8-K, as filed with the SEC on March 4, 2005 (File
No. 001-13437)
10.59** Form of Split-Dollar Insurance Agreement, incorporated by reference to
Current Report on Form 8-K, as filed with the SEC on March 4, 2005 (File
No. 001-13437)
10.60 Consulting Agreement dated February 28, 2005 between the Registrant and
The Yucaipa Companies, LLC, incorporated by reference to Current Report on
Form 8-K, as filed with the SEC on March 4, 2005 (File No. 001-13437)
10.61*+ Product Fulfillment Services Agreement dated as of March 17, 2004
between Barnes & Noble, Inc. and AEC One Stop Group, Inc.
14.1 Code of Business Conduct and Ethics of Source Interlink Companies, Inc., a
Delaware corporation, incorporated by reference to Current Report on Form
8-K, as filed with the SEC on March 4, 2005 (File No. 001-13437)
14.2 Code of Ethics for Chief Executive Officer and Financial Executives of
Source Interlink Companies, Inc., a Delaware corporation, incorporated by
reference to Current Report on Form 8-K, as filed with the SEC on March 4,
2005 (File No. 001-13437)
14.3 Code of Conduct for Directors and Executive Officers of Source Interlink
Companies, Inc., a Delaware corporation, incorporated by reference to
Current Report on Form 8-K, as filed with the SEC on March 4, 2005 (File
No. 001-13437)
48
21.1* Subsidiaries of the Registrant
23.1* Consent of BDO Seidman, LLP
31.1* Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer
31.2* Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer
32.1* Section 1350 Certification of Principal Executive Officer and Principal
Financial Officer
* Filed herewith.
** Indicates management contract or compensatory plan, contract or arrangement.
+ Certain material has been omitted pursuant to a request for confidential
treatment and such material has been filed separately with the Commission.
49
SOURCE INTERLINK COMPANIES, INC.
INDEX OF FINANCIAL STATEMENTS
AUDITED CONSOLIDATED FINANCIAL STATEMENT OF SOURCE INTERLINK COMPANIES, INC. PAGE
Report of Independent Registered Public Accounting Firm F-2
Consolidated Balance Sheets at January 31, 2005 and 2004 F-3
Consolidated Statements of Income for the three years in the period ended January 31, 2005 F-5
Consolidated Statements of Stockholders' Equity for the three years in the period ended January 31, 2005 F-6
Consolidated Statements of Cash Flows for the three years in the period ended January 31, 2005 F-7
Notes to Consolidated Financial Statements F-8
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors
Source Interlink Companies, Inc.
Bonita Springs, Florida
We have audited the consolidated balance sheets of Source Interlink Companies,
Inc. as of January 31, 2005 and 2004 and the related consolidated statements of
income, stockholders' equity and cash flows for each of the three years in the
period ended January 31, 2005. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Source Interlink
Companies, Inc. at January 31, 2005 and 2004 and the results of its operations
and its cash flows for each of the three years in the period ended January 31,
2005 in conformity with accounting principles generally accepted in the United
States of America.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of the Company's
internal control over financial reporting as of January 31, 2005, based on
criteria established in Internal Control - Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our
report dated April 8, 2005 expressed an unqualified opinion thereon.
/s/ BDO Seidman, LLP
Chicago, Illinois
April 8, 2005
F-2
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
January 31, 2005 2004
- ---------------------------------------------- ---------------- -----------------
ASSETS
CURRENT ASSETS
Cash $ 1,387 $ 4,963
Trade receivables, net 48,078 41,834
Purchased claims receivable 2,006 5,958
Inventories 16,868 17,241
Income tax receivable 2,275 2,067
Deferred tax asset 2,302 2,915
Advances under magazine export agreement - 6,830
Other 3,349 2,536
---------------- -----------------
TOTAL CURRENT ASSETS 76,265 84,344
---------------- -----------------
Property, plants and equipment 36,706 29,145
Less accumulated depreciation and amortization (14,375) (10,582)
---------------- -----------------
NET PROPERTY, PLANTS AND EQUIPMENT 22,331 18,563
---------------- -----------------
OTHER ASSETS
Goodwill, net 71,600 45,307
Intangibles, net 16,126 7,931
Deferred tax asset 2,903 908
Other 8,528 7,048
---------------- -----------------
TOTAL OTHER ASSETS 99,157 61,194
---------------- -----------------
$ 197,753 $ 164,101
================ =================
See accompanying notes to
Consolidated Financial Statements
F-3
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except par value)
January 31, 2005 2004
- ----------------------------------------------------------------------------------- --------------- -----------------
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Checks issued against future advances on revolving credit facility $ 1,951 $ 14,129
Accounts payable and accrued expenses (net of allowance for returns of $70,292
and $57,842 at January 31, 2005 and 2004, respectively) 25,274 44,741
Deferred revenue 2,205 1,680
Other 19 317
Current maturities of debt 5,630 4,059
--------------- -----------------
TOTAL CURRENT LIABILITIES 35,079 64,926
Debt, less current maturities 34,139 31,541
Other 852 560
--------------- -----------------
TOTAL LIABILITIES 70,070 97,027
--------------- -----------------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY
Contributed Capital:
Preferred Stock, $.01 par (2,000 shares authorized; none issued) - -
Common Stock, $.01 par (40,000 shares authorized; 23,849 and 18,991 shares
issued) 238 190
Additional paid-in-capital 150,269 102,297
--------------- -----------------
Total contributed capital 150,507 102,487
Accumulated deficit (23,696) (35,778)
Accumulated other comprehensive income (loss):
Foreign currency translation 1,439 932
--------------- -----------------
128,250 67,641
Less: Treasury Stock (100 shares at cost) (567) (567)
--------------- -----------------
TOTAL STOCKHOLDERS' EQUITY 127,683 67,074
--------------- -----------------
$ 197,753 $ 164,101
=============== =================
See accompanying notes to
Consolidated Financial Statements
F-4
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data)
Fiscal year ended January 31, 2005 2004 2003
- ---------------------------------------------------------------- --------------- ------------ ------------
Revenues $ 356,644 $ 315,791 $ 269,191
Costs of revenues 258,851 229,748 197,431
--------------- ------------ ------------
Gross profit 97,793 86,043 71,760
Selling, general and administrative expense 55,130 50,538 43,710
Fulfillment freight 21,067 16,381 14,721
Relocation expenses 2,450 1,730 1,926
Loss on sale of land and building 1,122 - -
--------------- ------------ ------------
Operating income 18,024 17,394 11,403
--------------- ------------ ------------
Other income (expense)
Interest expense (1,575) (3,427) (3,473)
Interest income 175 358 277
Write of deferred financing costs and original issue
discount (1,495) (865) -
Other 161 393 445
--------------- ------------ ------------
Total other expense (2,734) (3,541) (2,751)
--------------- ------------ ------------
Income from continuing operations before income taxes and
discontinued operation 15,290 13,853 8,652
Income tax expense 2,228 3,690 893
--------------- ------------ ------------
Income from continuing operations before discontinued operation 13,062 10,163 7,759
Loss from discontinued operation, net of tax (980) (115) (421)
--------------- ------------ ------------
Net income $ 12,082 $ 10,048 $ 7,338
=============== ============ ============
Earnings (loss) per share - basic
Continuing operations $ 0.57 $ 0.55 $ 0.42
Discontinued operations (0.04) (0.01) (0.02)
--------------- ------------ ------------
Total 0.53 0.54 0.40
=============== ============ ============
Earnings (loss) per share - diluted
Continuing operations 0.53 0.52 0.42
Discontinued operations (0.04) (0.01) (0.02)
--------------- ------------ ------------
Total $ 0.49 $ 0.51 $ 0.40
=============== ============ ============
Weighted average of shares outstanding - basic 22,963 18,476 18,229
Weighted average of shares outstanding - diluted 24,833 19,866 18,478
See accompanying notes to
Consolidated Financial Statements
F-5
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(in thousands)
Other
Common Stock Additional Comprehensive Treasury Stock Total
---------------- Paid - in Accumulated Income ---------------- Stockholders'
Shares Amount Capital Deficit (Loss) Shares Amount Equity
------ -------- ---------- ---------- ------- ------ ------- -------------
Balance, January 31, 2002 19,415 $ 194 $ 103,386 $ (53,164) $ (387) 1,126 $(6,486) $ 43,543
Net income 7,338 7,338
Foreign currency
translation 177 177
-------------
Comprehensive income 7,515
-------------
Issuance of common stock
in exchange for services 46 1 216 217
Exercise of stock options 17 - 76 76
Exercise of warrants 11 - 32 32
Purchase of treasury stock 100 (464) (464)
Retirement of treasury
stock (1,126) (11) (6,372) (1,126) 6,383
------ -------- ---------- ---------- ------- ------ ------- -------------
Balance, January 31, 2003 18,363 184 97,338 (45,826) (210) 100 (567) 50,919
Net income 10,048 10,048
Foreign currency
translation 1,142 1,142
-------------
Comprehensive income 11,190
-------------
Exercise of stock options 624 6 2,820 2,826
Tax benefit from stock
options exercised 924 924
Original issuance discount
of note payable from
warrants 936 936
Other 4 279 279
------ -------- ---------- ---------- ------- ------ ------- -------------
Balance, January 31, 2004 18,991 190 102,297 (35,778) 932 100 (567) 67,074
Net income 12,082 12,082
Foreign currency
translation 507 507
-------------
Comprehensive income 12,589
Exercise of stock options 1,058 10 5,915 5,925
Tax benefit from stock
options exercised 1,621 1,621
Public offering proceeds
(net of offering costs of
$3,226) 3,800 38 40,436 40,474
------ -------- ---------- ---------- ------- ------ ------- -------------
Balance, January 31, 2005 23,849 $ 238 $ 150,269 $ (23,696) $ 1,439 100 $ (567) $ 127,683
====== ======== ========== ========== ======= ====== ======= =============
See accompanying notes to
Consolidated Financial Statements
F-6
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SOURCE INTERLINK COMPANIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Years ended January 31, 2005 2004 2003
- ---------------------------------------------------------------- --------------- --------------- -------------
OPERATING ACTIVITIES
Net income 12,082 $ 10,048 $ 7,338
Adjustments to reconcile net income to net cash (used in)
provided by operating activities:
Depreciation and amortization 5,447 4,084 3,301
Provision for losses on accounts receivable 3,003 1,819 2,023
Deferred income taxes (1,382) (534) (1,178)
Deferred revenue 525 (497) (320)
Loss on sale of land and building 1,122 - -
Write off of deferred financing costs and original issue
discount 1,495 865 -
Other 32 1,047 (288)
Changes in assets and liabilities (excluding business
acquisitions):
(Increase) decrease in accounts receivable (10,256) 455 17,619
Decrease (increase) in inventories 610 (1,329) 1,200
Decrease in other current and non-current assets 706 2,011 614
Decrease in accounts payable and other liabilities (24,845) (5,673) (9,675)
--------------- --------------- -------------
CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES (11,461) 12,296 20,634
--------------- --------------- -------------
INVESTMENT ACTIVITIES
Capital expenditures (7,146) (2,113) (4,429)
Purchase of claims (87,230) (81,341) (79,789)
Payments received on purchased claims 91,181 83,144 75,396
Collections (advances) under magazine export agreement 6,830 (6,830) -
Payments under magazine import agreement (1,500) (1,000) (2,000)
Payments under magazine export agreement - (1,400) -
Acquisition of Innovative Metal Fixtures, Inc. - - (2,014)
Acquisition of Worldwide agreements (4,212) - -
Acquisition of Empire State News Corp. (3,352) - -
Acquisition of Promag Retail Services, LLC (12,473) - -
Proceeds from the sale of fixed assets 735 - -
Acquisition costs of Alliance Entertainment Corp. (2,585) - -
--------------- --------------- -------------
CASH USED IN INVESTING ACTIVITIES (19,752) (9,540) (12,836)
--------------- --------------- -------------
FINANCING ACTIVITIES
(Decrease) increase in checks issued against revolving credit
facilities (12,178) 7,518 6,611
Borrowings (repayments) under credit facilities 7,554 (27,733) (7,667)
Payments of notes payable (23,977) (5,974) (3,758)
Borrowing under notes payable 10,000 20,000 -
Proceeds from the issuance of common stock 46,399 2,826 108
Deferred financing cost (161)
Purchase of treasury stock - - (465)
--------------- --------------- -------------
CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 27,637 (3,363) (5,171)
--------------- --------------- -------------
(DECREASE) INCREASE IN CASH (3,576) (607) 2,627
CASH, beginning of period 4,963 5,570 2,943
--------------- --------------- -------------
CASH, end of period $ 1,387 $ 4,963 $ 5,570
=============== =============== =============
See accompanying notes to
Consolidated Financial Statements
F-7
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS
Source Interlink Companies, Inc. (the "Company") and its subsidiaries distribute
magazines direct to specialty and mainstream retailers, design, manufacture,
install and remove retail fixtures located at the check-out lane, manage
retailers' claims for rebates with magazine publishers, provide access to a
comprehensive database of point-of-sale data to retailers and product managers,
and manufacture high-end wood retail display fixtures.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Source Interlink
Companies, Inc. and its wholly-owned subsidiaries (collectively, the Company) as
of the date they were acquired. All significant intercompany accounts and
transactions have been eliminated.
USE OF ESTIMATES
The preparation of financial statements in accordance with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
REVENUE RECOGNITION
Magazine Fulfillment
Revenues from the sale of magazines the Company distributes are recognized at
the time of delivery less allowances for estimated returns. Revenues from the
sale of magazines to wholesalers that are not shipped through our distribution
centers are recognized at the later of notification from the shipping agent that
the product has been delivered or the on-sale date of the magazine. The Company
records a reduction in revenue for estimated magazine sales returns and a
reduction in cost of sales for estimated magazine purchase returns. Estimated
returns are based on historical sell-through rates.
Fulfillment & Return Processing Services
Revenues from performing fulfillment and return processing services are
recognized at the time the service is performed. The Company is generally
compensated on either a per-copy or per-pound basis based on a negotiated price
or a cost plus model.
Rebate Claim Filing
Revenues from the filing of rebate claims with publishers on behalf of retailers
are recognized at the time the claim is paid. The revenue recognized is based on
the amount paid multiplied by our commission rate. The Company has developed a
program (the "advance pay" program) whereby the Company will advance the claimed
amount less applicable commissions to the retailers and collect the entire
amount claimed from publishers for our own accounts. The Company accounts for
the advance as a purchase of a financial asset and records a receivable at the
time of purchase.
See accompanying notes to
Consolidated Financial Statements
F-8
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Information Products
Revenues from information product contracts are recognized ratably over the
subscription term, generally one year.
Custom Display Manufacturing
Revenues from the design and manufacture of custom display fixtures are
recognized when the retailer accepts title to the display. Transfer of title
usually occurs upon shipment. However, upon request from a customer, the product
can be stored for future delivery for the convenience of the customer. If this
occurs, we recognize revenue when the manufacturing and earnings processes are
complete, the customer accepts title in writing, the product is invoiced with
payment due in the normal course of business, the delivery schedule is fixed and
the product is segregated from other goods. Services related to the
manufacturing of displays such as freight, installation, warehousing and salvage
are recognized when the services are performed.
INVENTORIES
Inventories are valued at the lower of cost or market. Cost is determined by the
first-in, first-out ("FIFO") method.
PROPERTY, PLANTS & EQUIPMENT
Property and equipment are stated at cost. Depreciation is computed using the
straight-line method for financial reporting over the estimated useful lives as
follows:
Asset Class Life
- ----------------------- ---------
Buildings 40 years
Machinery and equipment 5-7 years
Vehicles 5-7 years
Furniture and fixtures 5-7 years
Computers 3-5 years
Leasehold improvements are amortized over the shorter of the useful life of the
asset or the life of the lease.
GOODWILL
Goodwill represents the excess of cost over the fair value of net assets
acquired in connection with business acquisitions. In accordance with SFAS 142,
goodwill and other intangible assets is tested for impairment at the reporting
unit level, which is defined as an operating segment or a component of an
operating segment that constitutes a business for which financial information is
available and is regularly reviewed by management. Management has determined
that the Company's reporting units are the same as its operating segments for
the purpose of allocating goodwill and the subsequent testing of goodwill for
impairment. Goodwill relates primarily to the In-Store Services segment, which
consists of acquired rebate claim filing and wire manufacturing operations. The
annual impairment review was completed in the first fiscal quarter of 2005, 2004
and 2003 and no impairment charge was necessary. The Company assesses goodwill
for impairment at least annually in the absence of an indicator of possible
impairment and immediately upon an indicator of possible impairment. Fair value
of the operating unit is determined based on a combination of discounted cash
flows and publicly traded company multiples
See accompanying notes to
Consolidated Financial Statements
F-9
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
and acquisition multiples of comparable businesses. For goodwill valuation
purposes only, the fair value of the operating segment is allocated to the
assets and liabilities of the operating segment to arrive at an implied fair
value of goodwill, based upon known facts and circumstances as if the
acquisition occurred currently. The difference between the carrying value and
the estimated fair value of the goodwill would be recognized as an impairment
loss.
INTANGIBLE ASSETS
The Company currently amortizes intangible assets over the estimated useful life
of the asset ranging from 5 to 15 years (See Footnote 6). When appropriate, the
Company commissions an independent expert to advise the Company on the useful
life of the intangible assets.
DEFERRED FINANCING FEES
Deferred financing fees are capitalized and amortized over the life of the
credit facility and are included in other long-term assets.
IMPAIRMENT OF LONG-LIVED ASSETS
The Company records impairment losses on long-lived assets used in operations,
other than goodwill, when events and circumstances indicate that the assets
might be impaired and the undiscounted cash flows estimated to be generated by
those assets are less than the carrying amount of those items. Our cash flow
estimates are based on historical results adjusted to reflect our best estimate
of future market and operating conditions. The net carrying value of assets not
recoverable is reduced to fair value. Our estimates of fair value represent our
best estimate based on industry trends and reference to market rates and
transactions.
CONCENTRATIONS OF CREDIT RISK
The Company has significant concentrations of credit risk in its Magazine
Fulfillment, In-Store Services and Wood Manufacturing segments. If the Company
experiences a significant reduction in business from its clients, the Company's
results of operations and financial condition may be materially and adversely
affected. The Company aggregates customers with a common parent when calculating
the applicable percentages. For magazine distribution the Company calculates
contribution to revenue based on the actual distribution and estimated
sell-through based on the Company's calculated sales return reserve.
During fiscal 2005, two customers (Barnes and Noble, Inc. and Borders Group,
Inc.) accounted for 53.2% (28.7% and 24.5%) of total revenues.
During fiscal 2004, these two customers accounted for 53.4% (28.3% and 25.1%) of
total revenues.
During fiscal 2003, these two customers accounted for 57.9% (30.0% and 27.9%) of
total revenues.
See accompanying notes to
Consolidated Financial Statements
F-10
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ALLOWANCE FOR DOUBTFUL ACCOUNTS
The Company provides for potential uncollectible accounts receivable at a level
management believes is sufficient based on customer specific information and
historical collection experience.
SHIPPING AND HANDLING CHARGES
Shipping and handling charges related to the distribution of magazines are not
included in Cost of Revenues. Shipping and handling costs totaled approximately
$21.1 million, $16.4 million and $14.7 million in 2005, 2004 and 2003,
respectively.
RELOCATION EXPENSES
During fiscal 2005, the Company incurred $2.5 million of expenses related
principally to distribution center relocations. The Company began expansion into
the mainstream retail market which resulted in distribution fulfillment centers
in Milan, OH, San Diego, CA and Kent, WA being moved to Harrisburg, PA and
Carson City, NV.
During fiscal 2004, the Company incurred $1.7 million of expenses related to
relocating its claims submission and fixture billing center, its Corporate
Headquarters, and its Magazine Fulfillment administrative offices to its new
facility in Bonita Springs, FL.
During fiscal 2003, the Company incurred $1.9 million of expenses related to the
relocations noted above. These costs consist of reimbursement of $1.2 million
for moving expenses, $0.2 million for severance payments and other costs.
The Company accounted for the relocations in accordance with FAS 146,
"Accounting for Costs Associated with Exit or Disposal Activities". FAS 146
requires recording costs associated with an exit or disposal activity at their
fair values when a liability has been incurred.
INCOME TAXES
The Company accounts for income taxes under an asset and liability approach that
requires the recognition of deferred tax assets and liabilities for the expected
future tax consequences of events that have been recognized in the Company's
financial statements or tax returns. In estimating future tax consequences, the
Company generally considers all expected future events other than enactments of
changes in the tax laws or rates.
FOREIGN CURRENCY TRANSLATION AND TRANSACTIONS
The financial position and results of operations of the Company's foreign
subsidiaries are determined using local currency as the functional currency.
Assets and liabilities of these subsidiaries are translated at the exchange rate
in effect at each year-end. Income statement accounts are translated at the
average rate of exchange prevailing during the year. Translation adjustments
arising from the use of differing exchange rates from period to period are
included in the other comprehensive income account in stockholders' equity.
Gains and losses resulting from foreign currency transactions, which are not
material, are included in the Consolidated Statements of Income.
See accompanying notes to
Consolidated Financial Statements
F-11
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
COMPREHENSIVE INCOME
Comprehensive income is defined to include all changes in equity except those
resulting from investments by owners and distributions to owners. The Company's
comprehensive income item is foreign currency translation adjustments.
EARNINGS PER SHARE
In February 1997, the Financial Accounting Standards Board issued FAS No. 128,
"Earnings per Share," which requires the presentation of "basic" earnings per
share, computed by dividing net income available to common shareholders by the
weighted average number of common shares outstanding for the period, and
"diluted" earnings per share, which reflects the potential dilution that could
occur if securities or other contracts to issue common stock were exercised or
converted into common stock or resulted in the issuance of common stock that
then shared in the earnings of the entity.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of accounts receivable and accounts payable approximates
fair value due to their short-term nature. The carrying amount of debt including
credit facilities approximates fair value due to their stated interest rate
approximating a market rate. These estimated fair value amounts have been
determined using available market information or other appropriate valuation
methodologies.
ACCOUNTING FOR STOCK-BASED COMPENSATION
FAS No. 123, "Accounting for Stock-Based Compensation" defined a fair value
method of accounting for stock options and other equity instruments. Under the
fair value method, compensation cost is measured at the grant date based on the
fair value of the award and is recognized over the service period, which is
usually the vesting period. As provided in FAS No. 123, the Company elected to
apply Accounting Principles Board ("APB") Opinion No. 25 and related
interpretations in accounting for its stock-based compensation plans. No stock
based compensation was reflected in the fiscal 2005, 2004 or 2003 net income
related to our stock option plans as all options granted in those years had an
exercise price equal to or greater than the market value of the underlying stock
on the date of grant.
On December 15, 2004, the FASB issued a revision of the standard entitled SFAS
No. 123(R), Share Based Payment, which requires all companies to measure
compensation cost for all share-based payments, including stock options, at fair
value. Publicly traded companies must apply this standard as of the beginning of
the first annual period that begins after December 15, 2005. This statement
applies to all awards granted after the required effective date and to awards
modified, repurchased, or cancelled after that date. The cumulative effect of
initially applying this Statement, if any, is recognized as of the required
effective date. The company has not completed its evaluation of the impact of
adopting FASB 123R on its consolidated financial statements, but anticipates
that more compensation costs will be recorded in the future if the use of
options for employees and director compensation continues as in the past. Under
the revised standard the Company will be required to recognize compensation
expense on any unvested portion of grants not previously accounted for under the
fair-value-based method.
See accompanying notes to
Consolidated Financial Statements
F-12
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following is a reconciliation of net income per weighted average share had
the Company adopted FAS No. 123 (in thousands except per share amounts):
2005 2004 2003
------------------ ------------------ -----------------
Net income (as reported) $ 12,082 $ 10,048 $ 7,338
Stock compensation costs, net of tax (423) (1,330) (2,191)
------------------ ------------------ -----------------
Pro-forma net income $ 11,659 $ 8,718 $ 5,147
================== ================== =================
Weighted average shares, basic 22,963 18,476 18,229
Weighted average shares, diluted 24,833 19,866 18,478
Basic earnings per share - as reported $ 0.53 $ 0.54 $ 0.40
Diluted earnings per share - as reported 0.49 0.51 0.40
Basic earnings per share - pro-forma $ 0.51 $ 0.47 $ 0.28
Diluted earnings per share - pro-forma 0.47 0.44 0.28
The fair value of each option grant is estimated on the grant date using the
Black-Scholes option pricing model with the following assumptions:
Year Ended January 31, 2005 2004 2003
- ----------------------- ----------- ------------- ------------
Dividend yield 0% 0% 0%
Expected volatility 0.50 0.50 0.50
Risk-free interest rate 2.18%-2.86% 2.16% - 2.58% 2.21% - 4.32%
RECLASSIFICATIONS
Certain prior year amounts have been reclassified in the consolidated financial
statements to conform with current year presentation.
RECENT ACCOUNTING PRONOUNCEMENTS
In November 2004, the FASB issued SFAS No. 151, Inventory Costs - an amendment
of ARB no. 43, Chapter 4. This statement amends the guidance in ARB No. 43,
Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of
idle facility expense, freight, handling costs and wasted material (spoilage).
It is effective for fiscal years beginning after June 15, 2004 and is not
expected to have a material impact on the Company.
In December 2004, the FASB issued FSP 109-1, Application of FASB Statement No.
109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production
Activities Provided by the American Jobs Creation Act of 2004. The FSP states
that the impact of this deduction should be accounted for as a special deduction
rather than a rate reduction. It was effective immediately and has no impact on
the Company's 2005 consolidated financial statements. The Company is currently
reviewing its options related to the deduction and is currently unable to
determine whether it may have a material impact in the future.
2. BUSINESS COMBINATIONS AND ASSET ACQUISITIONS
Magazine Import and Export Acquisition
In May, 2002, the Company entered into an agreement giving the Company the right
to distribute domestically a group of foreign magazine titles. The agreement
called for an initial payment of $2.0 million, $1.0 million in fiscal 2004 and
additional contingent payments up to $2.5 million spread over the two years
ended May 2005 based on the overall gross profit generated from the sale of
these titles.
In March, 2003, the Company entered into an agreement giving the Company the
right to distribute internationally a
See accompanying notes to
Consolidated Financial Statements
F-13
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
group of domestic magazine titles. The agreement called for an initial payment
of $1.4 million, guaranteed payments totaling $4.2 million spread over the next
four fiscal years, and additional contingent payments up to $5.6 million based
on the overall gross profit generated from the Company's international sales of
these titles. Guaranteed payments under both of these agreements were
capitalized at inception and were included in intangible assets and were being
amortized over fifteen years, the term of the agreements.
In November 2004, these distribution agreements were terminated when the Company
acquired all import and export assets, WMS, Inc. naming rights and other
intangibles including a non-compete by the seller. The purchase price of the
import and export businesses was approximately $14.1 million (after an allowed
reduction of the purchase price for the payments made by the Company under the
prior leases agreements). The purchase price was comprised of $4.2 million paid
in cash on the last business day of November 2004 and notes payable in the
principal amount of $7.7 million. The first note of $8.9 million is payable over
13 quarters in equal installments of $0.7 million. In addition, a second note
payable in the amount of $1.0 million is payable in full on May 1, 2005.
Since the company has historically operated these magazine import and export
businesses under leases, included in the magazine fulfillment segment, results
of operations for the import and export businesses are included in the statement
of operations for the years ended January 31, 2005, 2004 and 2003 respectively.
Thus, this acquisition was not material to the Company's operations.
Under the original export lease agreement, the Company agreed to pay the prior
owner's outstanding trade payables out of the collections of the prior owner's
outstanding receivables. Amounts collected in excess of payments made or
payments in excess of collection are to be settled at a future date. The balance
was paid in full in November 2004.
In conjunction with this acquisition, the assets liabilities were allocated as
follows (in thousands):
- -----------------------------------------------------------------------------
Intangible assets:
Goodwill 8,529
Customer lists and non-compete agreement 3,400
Total assets acquired 11,929
Less: Additional notes payable issued (7,717)
-
- -----------------------------------------------------------------------------
Total cash paid $ 4,212
=============================================================================
PROMAG Retail Services, LLC Acquisition
In August 2004, the Company acquired all customer based intangibles (i.e., all
market composition, market share and other value) of the claiming and
information services of PROMAG Retail Services, LLC ("Promag") for approximately
$13.2 million. Of the $13.2 million purchase price, $10.0 million was funded
from a note payable with Wells Fargo Foothill noted in Footnote 7 and $0.75
million in a promissory note payable over a three year period to Promag in
quarterly installments of approximately $0.05. The results of Promag's
operations have been included in our consolidated statements of income since
August 1, 2004.
Promag provides claim filing services related to rebates owed retailers from
publishers or their designated agent throughout the United States and Canada.
Goodwill and other intangible assets recorded in connection with the transaction
totaled $13.2 million. The intangible assets are subject to amortization and
consist primarily of customer contracts and non-compete agreements that are
amortized on a straight-line basis over a weighted-average useful life of 12.77
years. The fair value assigned to intangible assets and the related
weighted-average useful life was based on valuations prepared by an independent
third party appraisal firm using estimates and assumptions provided by
management. The goodwill and intangible assets were assigned entirely to our
In-Store Services segment. This acquisition was not material to the Company's
operations.
In conjunction with this acquisition, the assets liabilities were allocated as
follows (in thousands):
- -----------------------------------------------------------------------------
Intangible assets:
Goodwill 8,723
Customer lists and non-compete agreement 4,500
Total assets acquired 13,223
Less: Note payable issued (750)
-
- -----------------------------------------------------------------------------
Total cash paid $12,473
=============================================================================
Empire State News Corp. Acquisition
In September 2004, the Company acquired substantially all of the operating
assets and liabilities of Empire State News Corp. ("Empire"), a magazine
wholesaler in northwest New York State for approximately $5.0 million. The
purchase price consisted of $3.4 million of cash paid and $1.6 million of
deferred consideration in the form of two notes payable (see Footnote 7) and
deferred consideration, subject to finalization of working capital adjustments
in accordance with the purchase agreement. The results of Empire's operations
have been included in our consolidated statements of income since September 26,
2004. The total cost of the acquisition was allocated to the assets acquired and
liabilities assumed based on their respective fair values in accordance with FAS
141, Business Combinations ("FAS 141"). Goodwill recorded in connection with the
transaction totaled $8.7 million. The fair value assigned to goodwill was based
on valuations prepared by an independent third party appraisal firm using
estimates and assumptions provided by management. The goodwill was assigned
entirely to our Magazine Fulfillment segment. This acquisition was not material
to the Company's operations.
In conjunction with this acquisition, the assets liabilities were allocated as
follows (in thousands):
- -----------------------------------------------------------------------------
Current assets: 485
Fixed assets 1,902
Goodwill 8,612
Total assets acquired 10,999
Less: Current liabilities (6,080)
Less: Note payable issued (1,200)
Less: Other long-term liabilities (367)
- -----------------------------------------------------------------------------
Total cash paid $ 3,352
=============================================================================
3. TRADE RECEIVABLES
Trade receivables consist of the following (in thousands):
2005 2004
-------------- ----------------
Trade receivables $ 129,031 $ 112,504
Less allowances for:
Sales returns and other 78,404 66,102
Doubtful accounts 2,549 4,568
-------------- ----------------
80,953 70,670
-------------- ----------------
$ 48,078 $ 41,834
============== ================
See accompanying notes to
Consolidated Financial Statements
F-14
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. INVENTORIES
Inventories consist of the following (in thousands):
2005 2004
-------------------- -----------------
Raw materials $ 2,657 $ 2,278
Work-in-process 1,459 1,973
Finished goods:
Fixtures 1,407 761
Magazine inventory 11,345 12,229
-------------------- -----------------
$ 16,868 $ 17,241
==================== =================
In the event of non-sale, magazine inventories are generally returnable to the
publishers for full credit.
5. PROPERTY, PLANTS AND EQUIPMENT
Property, plants and equipment consist of the following (in thousands):
2005 2004
-------------------- -----------------
Land $ 870 $ 870
Buildings 8,809 7,081
Leasehold improvements 2,566 1,419
Machinery and equipment 10,806 8,780
Vehicles 354 332
Furniture and fixtures 3,855 3,722
Computers 9,446 6,941
-------------------- -----------------
Property, plants and equipment $ 36,706 $ 29,145
==================== =================
Depreciation expense from property, plants and equipment was $3.8 million, $3.3
million and $3.0 million for the fiscal years ended January 31, 2005, 2004 and
2003, respectively.
See accompanying notes to
Consolidated Financial Statements
F-15
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. GOODWILL AND INTANGIBLE ASSETS
A summary of the Company's intangible assets is as follows (in thousands):
2005 2004
-------------------- -----------------
Amortizable intangible assets:
Customer lists $ 16,025 $ 9,110
Non-compete agreements 1,000 -
-------------------- -----------------
17,025 9,110
Accumulated amortization (899) (1,179)
-------------------- -----------------
Intangibles, net $ 16,126 $ 7,931
==================== =================
All goodwill additions in fiscal 2005 are tax deductible.
Amortization expense from intangible assets was $1.2 million, $0.7 million and
$0.2 million for the fiscal years ended January 31, 2005, 2004 and 2003,
respectively.
Amortization expense for each of the five succeeding years is estimated to be
(in thousands):
Fiscal year Amount
- ----------- ------------
2006 $ 1,286
2007 1,240
2008 1,237
2009 1,233
2010 1,117
------------
Total $ 6,113
============
The changes in the carrying amount of goodwill, for the year ended January 31,
2005, are as follows:
Balance, Balance,
Jan. 31, Goodwill Foreign currency Jan. 31,
2004 Additions translation adjustments 2005
--------------------------------------------------------------------
Goodwill $45,307 25,926 367 $71,600
--------------------------------------------------------------------
All goodwill additions in fiscal 2005 are tax deductible.
7. DEBT
Debt consists of (in thousands):
2005 2004
-------------- ----------------
Revolving Credit facility - Wells Fargo Foothill $ 19,289 $ 11,735
Note payable - Wells Fargo Foothill 8,766 4,083
Note payable - Hilco Capital, net of $858
original issuance discount in 2004 - 14,142
Note Payable - magazine import and export (Note 2) 9,879 3,850
Notes payable to former owners of acquired company - 1,613
Note Payable - former owner of Empire 1,200 -
Other 635 177
-------------- ----------------
Debt 39,769 35,600
Less current maturities 5,630 4,059
-------------- ----------------
Debt, less current maturities $ 34,139 $ 31,541
============== ================
Wells Fargo Foothill Credit Facility
On October 30, 2003, the Company entered into a credit agreement with Wells
Fargo Foothill. The credit agreement enables the Company to borrow up to $45.0
million under a revolving credit facility and provided a $5.0 million term note
payable. The credit agreement is secured by all of the assets of the Company.
In August 2004, the Company amended the credit facility with Wells Fargo
Foothill. The amended facility now extends through October 31, 2009 and provides
for a $10 million term note payable that bears interest at the prime rate plus
2.0% (7.25% at January 31, 2005). In addition, the Company reduced the $45.0
million revolving credit facility to $40.0 million; however the total credit
facility remains $50.0 million. The term note is payable over five years with
initial quarterly installments of $0.25 million payable over four quarters
beginning October 31, 2004. The quarterly installments increase to $0.35, $0.50,
$0.65 and $0.75 million, respectively, over the subsequent four years.
See accompanying notes to
Consolidated Financial Statements
F-16
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Borrowings under the revolving credit facility bear interest at a rate equal to
the prime rate (5.25% at January 31, 2005) plus a margin up to 0.5% (the
applicable margin was 0.0% at January 31, 2005) based on an availability
calculation and carries a facility fee of 1/4% per annum on the difference
between $40 million and the average principal amount outstanding under the
facility including advances under the revolving credit facility and letter of
credits.
The original $5.0 million term note payable bore interest at a rate equal to the
prime rate plus 2.5%. The note was payable in equal principal installments of
$0.1 million per month plus current interest. The balance on the note payable
was paid in full during the quarter ended April 30, 2004.
Under the credit agreement, the Company is limited in its ability to declare
dividends or other distributions on capital stock or make payments in connection
with the purchase, redemption, retirement or acquisition of capital stock. There
are also limitations on capital expenditures and the Company is required to
maintain certain financial ratios. At January 31, 2005, we were in compliance
with all financial and other covenants.
Availability under the facility is limited by the Company's borrowing base
calculation, as defined in the agreement. The calculation resulted in unused
availability, after consideration of outstanding letters of credit of $1.8
million, of $12.9 million at January 31, 2005. Interest in the amount of $0.2
million was accrued at January 31, 2005 and 2004.
This agreement was amended on February 28, 2005. See Footnote 19 for additional
information.
Hilco Capital Note Payable
On October 30, 2003, the Company entered into a credit agreement with Hilco
Capital. The note bore a value at maturity of $15.0 million and was recorded net
of the original issuance discount. Upon the closing of the agreement, Hilco
received a five year warrant to purchase up to 400,000 shares of the Company's
common stock at $8.04 per share. The warrants were valued at $.9 million using a
Black Scholes option pricing model. The value of these warrants was recorded as
an original issuance discount to the term loan and was to be amortized over the
term of the loan using the effective interest method. The term loan paid in full
during the year ended January 31, 2005. In conjunction with the prepayment of
notes payable, the remaining original issue discount of approximately $0.86
million and $0.64 million of deferred financing costs were written off.
Notes Payable to Former Owners of Acquired Companies
In connection with the acquisition of the assets of Empire, the Company issued
notes payable totaling $1.2 million to Empire and one of the former owners of
Empire. The notes payable bear interest at the lowest rate per annum allowable
under the Internal Revenue Service Code Section 1274, which was 2.35% as of
January 31, 2005 and are payable ratably over four fiscal years beginning with
the quarter ending January 31, 2005.
In connection with the acquisition of Interlink, the Company assumed debt to the
former owners of International Periodical Distributors, Inc. ("IPD").
Previously, the Company was disputing the remaining amounts owed and commenced
legal action requesting the court release the Company of any further obligation
under these arrangements. The notes were due in fiscal 2003 and bore interest of
12%, which the Company continued to accrue pending the outcome of the
litigation. In March 2004, the Company and the former owners settled the notes
payable, interest accrued thereon, and the indemnification claim by the Company
paying a total of $1.6 million.
The aggregate amount of debt maturing in each of the next five fiscal years is
as follows (in thousands):
See accompanying notes to
Consolidated Financial Statements
F-17
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Amount
--------
2006 $ 5,630
2007 5,142
2008 5,428
2009 3,514
2010 20,055
--------
$ 39,769
========
At January 31, 2005 and 2004, unamortized deferred financing fees were
approximately $1.8 and $2.6 million, respectively.
8. DISCONTINUED OPERATION
In November 2004, the Company sold and disposed of its secondary wholesale
distribution operation for $1.4 million, in order to focus more fully on its
domestic and export distribution. All rights owned under the secondary wholesale
distribution contracts were assigned, delivered, conveyed and transferred to the
buyer, an unrelated third party. All assets and liabilities of the secondary
wholesale distribution operation were not assumed by the buyer. The Company
recognized a gain on sale of this business of $1.4 million ($0.8 net of tax) in
the fourth quarter of fiscal year 2005.
The following amounts related to the Company's discontinued operation have been
segregated from continuing operations and reflected as discontinued operations
(in thousands):
2005 2004 2003
---------------- ---------------- ---------------
Revenue $ 13,380 $ 17,343 $ 21,704
================ ================ ===============
Loss before income taxes $ (3,033) $ (191) $ (702)
Income tax benefit 1,213 76 281
---------------- ---------------- ---------------
Loss from discontinued operation, net of tax (1,820) (115) (421)
---------------- ---------------- ---------------
Pre-tax gain on sale of discontinued business 1,400 - -
Income tax expense (560) - -
---------------- ---------------- ---------------
Gain on sale of business, net of tax 840 - -
---------------- ---------------- ---------------
Discontinued operations, net of tax $ (980) $ (115) $ (421)
================ ================ ===============
See accompanying notes to
Consolidated Financial Statements
F-18
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. EARNINGS PER SHARE
A reconciliation of the denominators of the basic and diluted earnings per share
computations are as follows (in thousands):
2005 2004 2003
------ ------- ------
Weighted average number of common shares outstanding 22,963 18,476 18,229
Effect of dilutive securities:
Stock options and warrants 1,870 1,390 249
Weighted average number of common shares outstanding - as
adjusted 24,833 19,866 18,478
Certain items were excluded from the dilution calculation for the following
reasons (shares in thousands):
At January 31, 2005, options and warrants to purchase 225 and 26 shares of
common stock, respectively, were not included in the computation of diluted
earnings per share because the option's and warrant's exercise price was greater
than the average market price of the Company's common stock for 2005.
At January 31, 2004, options and warrants to purchase 817 and 26 shares of
common stock, respectively, were not included in the computation of diluted
earnings per share because the option's and warrant's exercise price was greater
than the average market price of the Company's common stock for 2004.
At January 31, 2003, options and warrants to purchase 3,484 and 234 shares of
common stock, respectively, were not included in the computation of diluted
earnings per share because the option's and warrant's exercise prices was
greater than the average market price of the Company's common stock for 2003.
10. INCOME TAXES
Provision (benefit) for federal and state income taxes in the consolidated
statements of income for income from continuing operations before income taxes
consists of the following components (in thousands):
2005 2004 2003
----------------- ----------------- ---------------
Current
Federal $ 2,627 $ 3,292 $ 870
State 539 580 169
Foreign 444 482 485
----------------- ----------------- ---------------
Total current 3,610 4,354 1,524
----------------- ----------------- ---------------
Deferred
Federal (1,608) (694) (531)
State 466 (9) (132)
Foreign (240) 39 32
----------------- ----------------- ---------------
Total deferred (1,382) (664) (631)
----------------- ----------------- ---------------
Total income tax expense $ 2,228 $ 3,690 $ 893
================= ================= ===============
See accompanying notes to
Consolidated Financial Statements
F-19
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following summary reconciles income taxes for continuing operations at the
maximum federal statutory rate with the effective rates for 2005, 2004 and 2003
(in thousands):
2005 2004 2003
----------------- ----------------- ---------------
Income tax expense at statutory rate $ 5,351 $ 4,848 $ 3,028
Change in valuation allowance (4,104) (3,208) (2,109)
State income tax expense, net of
federal income tax benefit 653 371 24
Difference in foreign tax rates (61) (104) (142)
Other, net 389 1,783 92
-------- --------- ---------
Income tax expense $ 2,228 $ 3,690 $ 893
======== ========= =========
Components of income from continuing operations before income taxes are as
follows (in thousands):
2005 2004 2003
--------- ----------- ----------
United States $ 14,259 $ 12,065 $ 6,712
Foreign 1,031 1,788 1,940
--------- ----------- ----------
$ 15,290 $ 13,853 $ 8,652
========= =========== ==========
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amount of the assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes. The sources of
the temporary differences and their effect on deferred taxes are as follows (in
thousands):
2005 2004
----------- ----------
Deferred tax assets
Net operating loss carryforwards $ 4,576 $ 5,030
Allowance for doubtful accounts 1,025 1,777
Goodwill 456 1,510
Deferred revenue 882 672
Other 918 296
----------- ----------
7,857 9,285
Less: Valuation allowance - (4,104)
----------- ----------
Deferred tax asset, net 7,857 5,181
----------- ----------
Deferred tax liabilities
Book/tax difference in capital assets 1,791 1,358
Prepaid expenses 861 -
----------- ----------
Total deferred tax liabilities 2,652 1,358
----------- ----------
Net deferred tax asset 5,205 3,823
=========== ==========
Classified as:
Current asset 2,302 2,915
Long-term asset 2,903 908
----------- ----------
Net deferred tax asset $ 5,205 $ 3,823
=========== ==========
At January 31, 2005, the Company had net operating loss ("NOL") carryforwards of
approximately $13,075 expiring as follows (in thousands):
Fiscal year Amount
- ----------- --------
2019 $ 1,834
2020 $ 11,241
========
See accompanying notes to
Consolidated Financial Statements
F-20
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Internal Revenue Service regulations limit the utilization of these operating
losses to approximately $1.2 million per year. Valuation allowances exist on
assets where there is uncertainty as to their future utilization. The Company's
valuation allowance related to NOL carryforwards. At January 31, 2005 the
Company reassessed the future utilization of such NOLs and determined that it is
more likely than not that the benefit of such NOLs will be realized and a
valuation allowance is no longer necessary.
11. RELATED PARTY TRANSACTIONS
The Company purchased legal services from Armstrong Teasdale LLP totaling
approximately $0.3, $0.7 and $0.5 million for the years ended January 31, 2005,
2004 and 2003, respectively. Mr. Kenneth Teasdale is Chairman of Armstrong
Teasdale LLP and has served as a director on the Company's Board of Directors
since March 2000.
12. COMMITMENTS
Leases
The Company leases office and manufacturing space, an apartment, computer
equipment, and vehicles under leases that expire over the next five years.
Management expects that in the normal course of business, leases will be renewed
or replaced with other leases.
Rent expense was approximately $5.5 million, $5.9 million and $4.9 million for
the years ended January 31, 2005, 2004 and 2003, respectively.
Future minimum payments, by year and in the aggregate, under non-cancelable
operating leases with initial or remaining terms of one year or more consisted
of the following at January 31, 2005 (in thousands):
Year Ending January 31, Amount
- ----------------------- --------
2006 $ 5,210
2007 4,088
2008 3,754
2009 3,534
2010 3,419
Thereafter 14,221
--------
$ 34,226
========
LITIGATION AND CONTINGENCIES
Litigation
The Company has pending certain legal actions and claims, which were incurred in
the normal course of business, and is actively pursuing the defense thereof. In
the opinion of management, these actions and claims are either without merit or
are covered by insurance and will not have a material adverse effect on the
Company's financial condition, results of operations or liquidity.
13. EMPLOYEE BENEFIT PLANS
Stock Option Plans
Under the Company's stock option plans, options to acquire shares of Common
Stock have been made available for grant to certain employees and non-employee
directors. Each option granted has an exercise price of not less than 100% of
the market value of the Common Stock on the date of grant. The contractual life
of each option is generally 10 years. The vesting of the grants varies according
to the individual options granted.
See accompanying notes to
Consolidated Financial Statements
F-21
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Range of Weighted
Number of Exercise Average
Options Prices Exercise Price
--------- ---------------- --------------
Options outstanding at January 31, 2002 4,326,399 $ 1.66 - $ 21.60 $ 7.46
Options granted 926,750 4.27 - 6.00 4.83
Options forfeited or expired (395,633) 1.66 - 16.63 5.89
Options exercised (16,599) 2.42 - 5.00 4.63
--------- ---------------- -----------
Options outstanding at January 31, 2003 4,840,917 2.42 - 21.60 7.09
Options granted 826,750 4.56 - 9.66 5.09
Options forfeited or expired (141,972) 4.21 - 16.63 7.29
Options exercised (624,661) 2.42 - 5.94 4.52
--------- ---------------- -----------
Options outstanding at January 31, 2004 4,901,034 2.42 - 21.60 7.07
Options granted 223,500 8.58 - 12.55 9.40
Options forfeited or expired (586,089) 4.56 - 21.60 12.37
Options exercised (982,446) 2.42 - 8.04 5.53
--------- ---------------- -----------
Options outstanding at January 31, 2005 3,555,999 $ 2.42 - $21.60 $ 6.48
========= ================ ===========
The following table summarizes information about the stock options outstanding
at January 31, 2005:
Options Outstanding Options Exercisable
--------------------------------------------- -----------------------
Weighted Remaining Weighted
Number Average Contractual Numbers Average
Exercise Price Outstanding Price Life (Months) Exercisable Price
- --------------- ----------- -------- ------------ ----------- --------
$ 2.42 - $ 5.00 1,719,793 $ 4.65 29 - 96 1,266,360 $ 4.70
5.01 - 7.50 723,339 5.32 12 - 94 703,422 5.31
7.51 - 10.00 667,167 8.10 46 - 115 490,834 7.97
10.01 - 15.00 336,500 11.85 47 - 111 325,167 11.85
15.01 - 21.60 109,200 16.61 56 - 62 109,200 16.61
----------- -------- ------------ --------
3,555,999 $ 6.48 2,894,983 $ 6.65
=========== ======== ============ ========
Options exercisable at January 31, 2004 totaled 4,281,918 with a weighted
average exercise price of $7.35.
Options exercisable at January 31, 2003 totaled 3,816,021 with a weighted
average exercise price of $7.58.
The weighted average fair value of each option granted during the year was
$3.40, $1.82 and $1.80 (at grant date) in 2005, 2004, and 2003, respectively.
The options were issued at exercise prices which were equal to or exceeded
quoted market price at the date of grant.
At January 31, 2005, 376,816 shares were available for grant under the plans.
Profit Sharing and 401(k) Plan
The Company has a combined profit sharing and 401(k) Plan. Annual contributions
to the profit sharing portion of the Plan are determined by the Board of
Directors and may not exceed the amount that may be deducted for federal income
tax purposes. There were no profit sharing contributions charged against
operations for the years ended January 31, 2005, 2004, and 2003.
Under the 401(k) portion of the Plan, all eligible employees may elect to
contribute 2% to 20% of their compensation up to the maximum allowed under the
Internal Revenue Code. The Company matches one half of an employee's
See accompanying notes to
Consolidated Financial Statements
F-22
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
contribution, not to exceed 5% of the employee's salary. The amounts matched by
the Company during the years ended January 31, 2005, 2004, and 2003 pursuant to
this Plan were approximately $0.3 million, $0.4 million and $0.3 million,
respectively.
Union Plan
At January 31, 2005, 221 of the Company's 1,228 employees were members of a
collective bargaining unit. The Company is party to three collective bargaining
agreements, which expire on December 31, 2005, September 30, 2007 and January
31, 2008. Contributions to the union funds were approximately $0.3 million, $0.4
million and $0.4 million for the years ended January 31, 2005, 2004, and 2003,
respectively.
Stock Award Plan
In September 1996, the Company adopted its Stock Award Plan for all employees
and reserved 41,322 shares of Common Stock for such plan. Under the plan, the
Stock Award Committee, appointed by the Board of Directors of the Company, shall
determine the employees to whom awards shall be granted. No awards were granted
during the years ended January 31, 2005, 2004, or 2003.
14. WARRANTS
The following table summarizes information about the warrants for common stock
outstanding at January 31, 2005:
Exercise Number Number Date of Date of
Price Outstanding Exercisable Grant Expiration
- -------- ----------- ----------- ----------------- ----------------
$ 5.39 8,000 8,000 May 23, 2002 April 30, 2007
6.82 150,000 - October 23, 2003 October 23, 2013
8.01 16,668 - August 29, 2003 August 29, 2013
8.04 338,667 338,667 October 30, 2003 October 30, 2008
8.58 30,000 - August 30, 2004 August 30, 2014
14.00 25,644 25,644 May 23, 2002 August 31, 2005
15. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental information on the approximate amount of interest and income taxes
paid (refunded) is as follows (in thousands):
Year Ended January 31, 2005 2004 2003
- ---------------------- ------- -------- -------
Interest $ 2,168 $ 3,945 $ 3,545
Income Taxes $ 359 $ (2,962) $ 2,609
See accompanying notes to
Consolidated Financial Statements
F-23
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Significant non-cash activities were as follows:
In conjunction with the Empire acquisition, the Company incurred $1.6 million of
deferred consideration in the form of two notes payable totaling $1.2 million
(see Footnote 7) and deferred compensation of $0.4 million, subject to
finalization of working capital adjustments in accordance with the purchase
agreement.
In conjunction with the Worldwide acquisition, the Company issued an additional
$7.7 million in notes payable to acquire all import and export assets, naming
rights, other intangibles including a non-compete by the seller (see Footnote 2
and 7).
During 2005, the Hilco note payable was paid in full and the original issue
discount of $0.9 million was written off and unamortized deferred financing fees
of $0.64 million were also written off.
During 2004, in connection with the magazine export agreement discussed in Note
2, a liability of $4.2 million was recognized for the guaranteed payments owed
under the agreement
During 2004, in connection with the closing of the Wells Fargo Foothill credit
facility, the outstanding balances (including any accrued but unpaid interest
and fees) with Bank of America and Congress Financial were paid in full.
Termination of our existing facilities resulted in a write-off of the related
unamortized deferred loan charges of $0.9 million.
The Hilco Capital note payable was recorded net of an original issuance discount
related to the 400,000 warrants (total value at $0.9 million) issued upon close.
During 2003, the Company retired 1.1 million shares of common stock held in
treasury which was recorded at a cost of $6.4 million.
During 2003, as part of the relocation of our North Carolina claim submission
and fixture billing center to Bonita Springs, Florida, the assets related to the
land and building located in North Carolina totaling $1.8 million was placed on
the market for sale. As a result, the related assets were removed from our
capital asset accounts and were recorded in other long-term assets. This
property was sold during 2005 and a loss on the sale was recognized in the
amount of $1.1 million.
16. SHAREHOLDERS' EQUITY
In March 2004, the Company completed the sale of 3.8 million shares of common
stock at $11.50 per share, excluding underwriting discounts and expenses. Net
proceeds to the Company of approximately $40.5 million, after costs of issuance
of $3.2 million, were utilized to repay the Wells Fargo Foothill note payable
and revolving credit facility and all but a nominal amount on the Hilco Capital
note payable in March 2004.
17. SEGMENT FINANCIAL REPORTING
The Company's segment reporting is based on the reporting of senior management
to the Chief Executive Officer. This reporting combines the Company's business
units in a logical way that identifies business concentrations and synergies.
See accompanying notes to
Consolidated Financial Statements
F-24
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The reportable segments of the Company are Magazine Fulfillment, In-Store
Services, Wood Manufacturing and Shared Services. The accounting policies of the
segments are materially the same as those described in the Summary of Accounting
Policies.
The Magazine Fulfillment segment derives revenues from (1) selling and
distributing magazines, including domestic and foreign titles, to major
specialty retailers and wholesalers throughout the United States and Canada, (2)
exporting domestic titles internationally to foreign wholesalers or through
domestic brokers, (3) serving as a secondary national distributor, (4) providing
return processing services for major specialty retail book chains and (5)
servicing as an outsourced fulfillment agent.
The In-Store Services segment derives revenues from (1) designing,
manufacturing, and invoicing participants in front-end fixture programs, (2)
providing claim filing services related to rebates owed retailers from
publishers or their designated agent, (3) shipping, installation and removal of
front-end fixtures, and (4) providing information and management services
relating to retail magazine sales to U.S. and Canadian retailers and magazine
publishers. The Wood Manufacturing segment derives revenues from designing,
manufacturing and installing high-end wood store fixtures.
Shared Services consists of overhead functions not allocated to individual
operating segments. Previously, the majority of these expenses were included in
the In-Store Services segment. Comparable information is not available and not
presented for fiscal 2003.
Segment results follow (in thousands):
Magazine In-Store Wood Shared
Year ended January 31, 2005 Fulfillment Services Manufacturing Services Consolidated
- ----------------------------- ----------- -------- ------------- --------- ------------
Revenues $ 280,171 $ 54,103 $ 22,370 $ - $356,644
Cost of revenues 210,639 29,368 18,844 - 258,851
--------- -------- -------- -------- --------
Gross profit 69,532 24,735 3,526 - 97,793
Selling, general &
administrative 29,873 8,417 1,241 15,599 55,130
Fulfillment freight 21,067 - - - 21,067
Relocation expense 2,090 360 - - 2,450
Loss on sale of land
and building - - - 1,122 1,122
--------- -------- -------- -------- --------
Operating income (loss) $ 16,502 $ 15,958 $ 2,285 $(16,721) $ 18,024
========= ======== ======== ======== ========
Total assets $ 69,116 $ 93,418 $ 15,754 $ 19,465 $197,753
Goodwill, net 17,258 54,342 - - 71,600
Intangibles, net 11,800 4,326 - - 16,126
Depreciation and amortization 1,392 1,270 459 2,326 5,447
Capital expenditures 2,379 219 60 4,488 7,146
See accompanying notes to
Consolidated Financial Statements
F-25
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Magazine In-Store Wood Shared
Year ended January 31, 2004 Fulfillment Services Manufacturing Services Consolidated
- --------------------------- ----------- -------- ------------- -------- ------------
Revenues $238,471 $ 58,601 $18,719 $ - $315,791
Cost of revenues 179,460 33,931 16,357 - 229,748
-------- -------- -------- -------- -----------
Gross profit 59,011 24,670 2,362 - 86,043
Selling, general & 26,550 8,245 1,373 14,370 50,538
administrative
Fulfillment freight 16,381 - - - 16,381
Relocation expense 1,654 - - 76 1,730
-------- -------- -------- -------- --------
Operating income (loss) $ 14,426 $ 16,425 $ 989 $(14,446) $ 17,394
======== ======== ======== ======== ========
Total assets $ 47,718 $ 83,093 $ 15,114 $ 18,176 $164,101
Goodwill, net - 45,307 - - 45,307
Intangibles, net 7,824 107 - - 7,931
Depreciation and amortization 1,076 1,029 489 1,490 4,084
Capital expenditures 312 148 259 1,394 2,113
The following segment results are reported under the segment reporting effective
for fiscal 2003 (in thousands).
Magazine In-Store Wood
Year ended January 31, 2005 Fulfillment Services Manufacturing Consolidated
- --------------------------------- ----------- -------- ------------- ------------
Revenues $ 280,171 $ 54,103 $ 22,370 $356,644
Cost of revenues 210,639 29,368 18,844 258,851
----------- -------- -------- --------
Gross profit 69,532 24,735 3,526 97,793
Selling, general & administrative 29,873 24,016 1,241 55,130
Fulfillment freight 21,067 - - 21,067
Relocation expense 2,090 360 - 2,450
Loss on sale of land
and building - 1,122 - 1,122
----------- -------- -------- --------
Operating income (loss) $ 16,502 $ (763) $ 2,285 $ 18,024
=========== ======== ======== ========
Total assets $ 69,116 $112,883 $ 15,754 $197,753
Goodwill, net 17,258 54,342 - 71,600
Intangibles, net 11,800 4,326 - 16,126
Depreciation and amortization 1,392 3,596 459 5,447
Capital expenditures 2,379 4,707 60 7,146
Magazine In-Store Wood
Year ended January 31, 2004 Fulfillment Services Manufacturing Consolidated
- --------------------------------- ----------- -------- ------------- ------------
Revenues $238,471 $ 58,601 $ 18,719 $315,791
Cost of revenues 179,460 33,931 16,357 229,748
-------- -------- -------- --------
Gross profit 59,011 24,670 2,362 86,043
Selling, general & administrative 26,550 22,615 1,373 50,538
Fulfillment freight 16,381 - - 16,381
Relocation expense 1,654 76 - 1,730
-------- -------- -------- --------
Operating income (loss) $ 14,426 $ 1,979 $ 989 $ 17,394
======== ======== ======== ========
Total assets $ 47,718 $101,269 $ 15,114 $164,101
Goodwill, net - 45,307 - 45,307
Intangibles, net 7,824 107 - 7,931
Depreciation and amortization 1,076 2,519 489 4,084
Capital expenditures 312 1,542 259 2,113
See accompanying notes to
Consolidated Financial Statements
F-26
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Magazine In-Store Wood
Year ended January 31, 2003 Fulfillment Services Manufacturing Consolidated
- --------------------------------- ----------- -------- ------------- ------------
Revenues $189,960 $ 61,754 $ 17,477 $269,191
Cost of revenues 145,650 35,391 16,390 197,431
-------- -------- -------- --------
Gross profit 44,310 26,363 1,087 71,760
Selling, general & administrative 22,240 19,671 1,799 43,710
Fulfillment freight 14,721 - - 14,721
Relocation expense 85 1,841 - 1,926
-------- -------- -------- --------
Operating income $ 7,264 $ 4,851 $ (712) $ 11,403
======== ======== ======== ========
Total assets $ 32,862 $108,982 $ 15,395 $157,239
Goodwill, net - 44,750 - 44,750
Intangibles, net - 2,047 - 2,047
Depreciation and amortization 719 2,159 423 3,301
Capital expenditures 358 3,766 305 4,429
18. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Quarterly financial data for 2005 and 2004 has been restated due to the
discontinued operation as discussed in Footnote 8 and is as follows (in
thousands, except per share amounts):
Q1 Q2 Q3 Q4
---------- ---------- ---------- ----------
2005 April 30 July 31 October 31 January 31
---------- ---------- ---------- ----------
Revenues $ 82,181 $ 86,858 $ 90,756 $ 96,849
Gross profit 22,079 23,676 25,710 26,328
Income from continuing operations
before discontinued operation 633 4,063 4,029 4,337
Income (loss) from discontinued operation (135) 74 349 (1,268)
Net income 497 4,138 4,378 3,069
Earnings (loss) per share - basic
Continuing operations $ 0.03 $ 0.17 $ 0.17 $ 0.18
Discontinued operations (0.01) 0.01 0.02 (0.05)
---------- ---------- ---------- ----------
Total 0.02 0.18 0.19 0.13
========== ========== ========== ==========
Earnings (loss) per share - diluted
Continuing operations 0.03 0.17 0.16 0.17
Discontinued operations (0.01) 0.00 0.01 (0.05)
---------- ---------- ---------- ----------
Total 0.02 0.17 0.17 0.12
========== ========== ========== ==========
See accompanying notes to
Consolidated Financial Statements
F-27
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Q1 Q2 Q3 Q4
--------- ---------- ---------- ----------
2004 April 30 July 31 October 31 January 31
--------- ---------- ---------- ----------
Revenues $ 76,440 $ 81,733 $ 87,600 $ 70,018
Gross profit 20,127 22,492 24,341 19,083
Income from continuing operations
before discontinued operation 597 3,027 4,139 2,400
Income (loss) from discontinued operation 32 (35) (43) (69)
Net income 629 2,992 4,096 2,331
Earnings per share - basic
Continuing operations $ 0.04 $ 0.16 $ 0.22 $ 0.13
Discontinued operations 0.00 0.00 0.00 0.00
--------- --------- --------- ---------
Total 0.04 0.16 0.22 0.13
========= ========= ========= =========
Earnings per share - diluted
Continuing operations 0.04 0.15 0.20 0.11
Discontinued operations 0.00 0.00 0.00 0.00
--------- --------- --------- ---------
Total 0.04 0.15 0.20 0.11
========= ========= ========= =========
19. SUBSEQUENT EVENTS
Alliance Entertainment Corp. Acquisition and Amended Financing Arrangement
On November 18, 2004, Source Interlink Companies, Inc. ("Source"), Alliance
Entertainment Corp. ("Alliance") and Alligator Acquisition, LLC ("Merger Sub")
entered into an Agreement and Plan of Merger (the "Merger Agreement").
Concurrently, and in connection therewith, (i) Source and Alliance entered into
identical voting agreements (the "Source Voting Agreements") with each of
certain directors and officers of Source and (ii) Source, Alliance and AEC
Associates, LLC (the "Principal Alliance Stockholder") entered into a voting
agreement (the "Alliance Voting Agreement").
On February 28, 2005, we completed the merger with Alliance Entertainment
Corp, a logistics and supply chain management services company for the home
entertainment product market pursuant to the terms and conditions of the
Agreement and Plan of Merger Agreement dated as of November 18, 2005 (the
"Merger Agreement").
Alliance historically operated two business segments: the Distribution and
Fulfillment Services Group ("DFSG") and the Digital Medial Infrastructure
Services Group (the "DMISG"). Prior to the merger, on December 31, 2004,
Alliance disposed of all of the operations conducted by the DMISG business lines
through a spin-off to its existing stockholders. Consequently, in connection
with the merger, we acquired only the DFSG business and not the DMISG business.
The DMISG business represented approximately 1.8% and 1.4% of Alliance's
consolidated sales for the years ended December 31, 2004 and 2003, respectively.
The total purchase price of approximately $317.0 million consisted of
$304.7 million in Source Interlink common stock, representing approximately
26.9 million shares, $9.3 million related to the exchange of approximately
0.9 million shares of common stock on exercise of outstanding stock options,
warrants and other rights to acquire Alliance common stock and direct
transaction costs of $3.0 million. The value of the common stock was determined
based on the average market price of Source Interlink common stock over the
5-day period prior to and after the announcement of the merger in November 2004.
The value of the stock options was determined using the Black-Scholes option
valuation model.
In connection with the acquisition of Alliance, on February 28, 2005, we
entered into an amended and restated secured financing arrangement with Wells
Fargo Foothill, Inc., as arranger and administrative agent (the "Working Capital
Loan Agent") for each of the lenders that may become a participant in such
arrangement, and their successors and assigns (the "Working Capital Lenders")
pursuant to which the Working Capital Lenders will make revolving loans
("Working Capital Loans") to us and our subsidiaries of up to $250 million
("Advances") and provide for the issuance of letters of credit. The terms and
conditions of the arrangement are governed primarily by the Amended and Restated
Loan Agreement dated February 28, 2005 by and among us, our subsidiaries, and
Wells Fargo (the "Amended and Restated Loan Agreement").
The proceeds of the Working Capital Loans are to be used to (i) finance
transaction expenses incurred in connection with the merger of Source Interlink
and Alliance and the reincorporation of Source Interlink into Delaware, (ii)
repay certain existing indebtedness of Alliance and its subsidiaries, (iii)
repay certain existing indebtedness of Source Interlink to Wells Fargo under our
previous credit facility (including, without limitation, a $10 million term
loan) and (iv) for working capital and general corporate purposes, including the
financing of acquisitions.
See accompanying notes to
Consolidated Financial Statements
F-28
SOURCE INTERLINK COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Outstanding Advances bear interest at a variable annual rate equal to the
prime rate announced by Wells Fargo Bank, National Association's San Francisco
office, plus a margin of between 0% and 1.00% based upon a ratio of the
Registrant's EBITDA to interest expense ("Interest Coverage Ratio"). We also
have the option of selecting up to five traunches of at least $1 million each to
bear interest at LIBOR plus a margin of between 2.00% and 3.00% based upon our
Interest Coverage Ratio. To secure repayment of the Working Capital Loans and
other obligations of ours to the Working Capital Lenders, we and our
subsidiaries granted a security interest in all of their personal property
assets to the Working Capital Loan Agent, for the benefit of the Working Capital
Lenders. The Working Capital Loans mature on October 31, 2010.
See accompanying notes to
Consolidated Financial Statements
F-29
Report of Independent Registered Public Accounting Firm
Board of Directors
Source Interlink Companies, Inc.
Bonita Springs, Florida
The audits referred to in our report dated April 8, 2005, relating to the
consolidated financial statements of Source Interlink Companies, Inc., which are
referred to in Item 8 of this Form 10-K, included the audit of the accompanying
financial statement schedule. This financial statement schedule is the
responsibility of the Company's management. Our responsibility is to express an
opinion on this financial statement schedule based upon our audits. In our
opinion, such financial statement schedule presents fairly, in all material
respects, the information set forth therein.
/s/BDO Seidman, LLP
Chicago, Illinois
April 8, 2005
S-1
SCHEDULE II
SOURCE INTERLINK COMPANIES, INC.
Valuation and Qualifying Accounts Schedule
January 31, 2005
(in thousands)
Column A Column B Column C Column D Column E
- ------------------------------------------------------------------------------------------------------------
Charged to
Balance at Charged to other
beginning of costs and accounts - Balance at
Description period expenses describe (1) Deductions end of period
- ------------------------------------------------------------------------------------------------------------
Year ended January 31, 2005:
Allowance for doubtful accounts $ 4,568 $3,003 $ 200 $5,645 $ 2,126
Sales return reserves 64,566 356,691 3,147 346,000 78,404
Year ended January 31, 2004:
Allowance for doubtful accounts 5,925 1,819 - 3,176 4,568
Sales return reserves 36,994 317,303 - 289,731 64,566
Year ended January 31, 2003:
Allowance for doubtful accounts 6,142 2,023 - 2,240 5,925
Sales return reserves 40,076 232,706 - 235,788 36,994
(1) Additions due to acquisitions
S-2