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Coinstar 10-K 2007 Documents found in this filing:
Table of ContentsUNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-K (Mark One)
For the fiscal year ended December 31, 2006 OR
Commission File Number: 000-22555 COINSTAR, INC. (Exact name of registrant as specified in its charter)
(425) 943-8000 (Registrant’s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Common Stock, $0.001 par value Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.: Yes ¨ No x Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.: Yes ¨ No x 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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.) Yes ¨ No x The aggregate market value of the common stock held by non-affiliates of the registrant, based upon the closing price of our common stock on June 30, 2006 as reported on the NASDAQ Global Select Market, was approximately $328.2 million. Shares of Common Stock held by each executive officer and director and by each person who beneficially held more than 5% of the outstanding Common Stock have been excluded as these persons may be deemed to be affiliates. This determination of affiliate status in not necessarily a conclusive determination for other purposes. As of February 16, 2007, there were approximately 27,827,000 shares of the registrant’s Common Stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant’s definitive Proxy Statement for the 2007 annual meeting of stockholders are incorporated by reference in Part II and Part III of this Form 10-K. The definitive proxy statement will be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year to which the report relates.
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Table of ContentsSpecial Note Regarding Forward-Looking Statements This Annual Report on Form 10-K (“Annual Report”) contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “potential,” “predict,” “should” or “will,” or the negative of such terms. Forward-looking statements are only predictions and involve known and unknown risks, uncertainties and other factors, including the risks outlined under Item 1A, Risk Factors and elsewhere in this report, that may cause our or our industry’s actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. You should not place undue reliance on these forward-looking statements. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, performance or achievements. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law. Unless the context requires otherwise, the terms “Coinstar,” the “Company,” “we,” “us” and “our” refer to Coinstar, Inc. and its subsidiaries. Item 1. Business. Summary We are a multi-national company offering a range of solutions for retailers’ storefronts consisting of self-service coin counting; entertainment services such as skill-crane machines, bulk vending machines and kiddie rides; and e-payment services such as prepaid wireless products, stored value cards, payroll cards, prepaid debit cards and money transfer services. In addition, through our strategic investments in Redbox Automated Retail, LLC (“Redbox”) and Video Vending New York, Inc. (d.b.a. “DVDXpress”), we offer self-service DVD kiosks where consumers can rent or purchase movies. We also offer a range of point-of-sale terminals, stand-alone e-payment kiosks and e-payment enabled coin-counting machines in drugstores, universities, shopping malls, supermarkets and convenience stores in the United States, the United Kingdom and other countries. We launched our business in North America with the installation of the first Coinstar® coin-counting machine in the early 1990s and in 2001 we began offering our coin services in the United Kingdom. Since inception, our coin-counting machines have counted and processed more than 300 billion coins worth more than $15.5 billion in more than 435 million transactions. We own and operate more than 13,500 coin-counting machines in the United States, Canada, Puerto Rico and the United Kingdom, of which approximately 8,200 are e-payment enabled, and more than 300,000 entertainment services machines in the United States and Mexico. We also utilize more than 14,000 point-of-sale terminals for e-payment services in the United States and the United Kingdom. Our 2004 acquisition of ACMI Holdings, Inc. and its subsidiaries (collectively, “ACMI”), our 2005 acquisition of The Amusement Factory L.L.C. (“Amusement Factory”), our strategic investments with Redbox and DVDXpress, as well as our 2006 acquisition of Travelex Money Transfer Limited (now known as “Coinstar Money Transfer” or “CMT”) have significantly broadened our base of existing and potential retailers and the depth and reach of our sales and field service forces, providing greater opportunity to cross-sell our coin, entertainment and e-payment services. We have more than 1,100 field service employees throughout the United States and internationally, who have broadened our geographic reach to develop and maintain strong relationships with retailers. With the combination of coin, entertainment and e-payment services, we are positioned as a single-source supplier for retailers to capitalize on the 4th Wall™, an area between the cash registers and front door of retail locations, that in the past has generally not been managed to optimize revenue per square foot. We are headquartered in Bellevue, Washington, where we maintain most of our sales, marketing, research and development, quality control, customer service operations and administration. In addition, our main
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Table of Contentsentertainment services office is located in Louisville, Colorado. As of December 31, 2006, we had approximately 1,900 employees. We were incorporated in Delaware on October 12, 1993. Coin services We are the leader in the self-service coin-counting services market. We own and operate the only multi-national fully automated network of self-service coin-counting machines across the United States, Canada, Puerto Rico and in the United Kingdom. We estimate that at any one time, there is more than $10.5 billion worth of coin sitting idle in households in the United States. In 2006, consumers processed more than $2.6 billion worth of coin through our coin-counting machines. We own and service all of our coin-counting machines, providing a “turn-key, headache-free” service to retailers. Our machines are easy to use, highly accurate, durable, easy to service and capable of processing up to 600 coins per minute. Consumers feed loose change into the machines, which count the change and then dispense vouchers or, in some cases, issue stored value cards or e-certificates, at the consumer’s election. Each voucher lists the dollar value of coins counted, less our transaction fee, which is typically 8.9% of the value of each transaction. There is no transaction fee to the consumer when a stored value card or e-certificate is issued. Our patented, proprietary technology helps us to maintain high up-time, remotely monitor performance and minimize the potential for losses associated with voucher fraud. Since we pay a percentage of our transaction fees to our retailers, our coin services benefit our retailers by providing an additional source of revenue. In addition, third-party studies show that our coin services increase foot traffic in our retailers’ stores and that approximately 46% of our customers spend all or a part of the proceeds of their vouchers in the store. Our leading coin services retailers include The Kroger Co. and Supervalu, Inc. supermarket chains, and our leading stored value cards or e-certificate offerings are Starbucks, Amazon.com and iTunes. Entertainment services We are the leading owner and operator of skill-crane and bulk vending machines in the United States. We estimate that the market for our entertainment services is approximately $1.1 billion annually in the United States. As with our coin services, we own and service all of our entertainment services machines, providing a convenient and trouble-free service to retailers. Our entertainment services machines consist primarily of skill-crane machines, bulk vending and kiddie rides, which are installed in more than 35,000 retail locations, totaling more than 300,000 pieces of equipment. The majority of our entertainment services revenue is derived from skill-crane machines that dispense plush toys, novelties and other items. For each play, customers maneuver the skill-crane into position and attempt to retrieve the desired item in the machine’s enclosed display area before play is ended. We utilize displays of quality merchandise, new product introductions and other merchandising techniques to attract new and repeat customers. Our leading entertainment services partners include Wal-Mart Stores, Inc. and Kmart, a subsidiary of Sears Holdings Corporation. Since we pay our retailers a portion of the fee per play, our entertainment services machines, like our coin-counting machines, provide an additional revenue stream for our retailers. In addition, our entertainment services machines add an element of entertainment for consumers. E-payment services We offer e-payment services, including activating and reloading value on prepaid wireless accounts, selling stored value cards, loading and reloading prepaid debit cards and prepaid phone cards, prepaid phones and providing payroll card services such as balance inquiry and wage statement printing. In addition, subsequent to the acquisition of CMT, we provide money transfer services in 142 countries. We believe these and other e-payment services represent a significant growth opportunity for us. We offer various e-payment services through 14,000 point-of-sale terminals, 400 stand-alone e-payment kiosks and 8,200 e-payment-enabled coin-counting machines in supermarkets, drugstores, universities, shopping malls and convenience stores. As
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Table of Contentswith our coin and entertainment services, our e-payment services provide an additional revenue stream for our retailers as we pay a fee through commissions earned on the sales of e-payment services. We have relationships with national wireless carriers, such as Sprint, Verizon, T-Mobile, Virgin Mobile and Cingular Wireless. Competitive strengths We believe our key competitive strengths are: Market leadership. We are the leader in the self-service coin-counting services market and in the skill-crane and bulk vending markets. We own and operate the only multi-national fully automated network of self-service coin-counting machines in the United States, Puerto Rico, Canada and the United Kingdom. To date, we have installed more than 13,500 of our coin-counting machines in those countries, which account for approximately 80% of the installed base in those markets. Currently, we estimate that 75% of the US population lives within five miles of one of our coin-counting machines. In addition, we are the leading owner and operator of skill-crane and bulk vending machines in the United States, with more than 300,000 pieces of equipment installed in more than 35,000 retail locations. Profitable, turn-key solutions for our retailers. We own, operate and maintain all of our machines and provide our retailers with low-maintenance, turn-key solutions and revenue-generating services. As a single-source provider with an array of products, we work with retailers to evaluate their front-of-store performance and related offerings to maximize revenue and profitability. Our studies show that our coin-counting machines increase foot traffic to host stores, and that approximately 46% of customers spend all or a part of the proceeds of their vouchers in the retailers’ store. Retailers also receive a portion of our revenues from our coin, entertainment and e-payment services transaction fees. We believe that these sources of revenue are very attractive to retailers. For example, our coin-counting machines and skill-crane machines generate five to eight times the supermarket average for profitability per square foot, among the most profitable per square foot in a supermarket, compared to the supermarket average reported in an independent survey. Differentiating, patented coin services technology. We believe that our proprietary technology sets us apart from our competitors. We have over 70 United States and international patents covering various aspects of our coin services business, including our networked coin-counting machines, coin-cleaning technology and voucher security features. Our coin-counting machines have a multi-step coin-cleaning process to remove debris, which helps prevent our equipment from becoming jammed. Our network allows our field service team to remotely monitor each individual coin-counting machine, thereby allowing us to optimize pickup of coins for maximum efficiency and perform maintenance on a cost-effective basis. These proprietary features allowed us to achieve availability rates on our coin-counting machines of approximately 95% in 2006, which underscores our reputation for providing reliable service. Our vouchers are encrypted using our proprietary technology to minimize the potential for losses associated with voucher fraud. We believe that the combination of our proprietary technology and reliable machine performance results in a preference for our services compared to our competitors. Barriers to entry. We believe that our proprietary network of coin-counting machines combined with our wide geographic reach and existing relationships with our retailers, would require a substantial investment of time and resources for other companies to enter the market and compete effectively against us in the self-service coin-counting and entertainment services markets. In the last 13 years, we have invested more than $390 million in capital equipment and research and development to build our network, and believe that this investment represents a significant competitive barrier to entry. In addition, the scale and size of our entertainment services allows us to achieve better economies of scale and provide higher quality merchandise in our machines. We believe that any potential competitors in the skill-crane and bulk vending markets would need to invest significant capital and secure relationships with large-scale retailers in order to challenge our leadership in those markets. In addition, we believe that our existing relationships with retailers and a broad range of e-payment related product offerings gives us a competitive edge in the e-payment services market.
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Table of ContentsConsistent and diversified revenue streams and stable operating cash flow. Our revenue and operating cash flows have increased each year for the last eight years. Our diversified revenue streams, which consist primarily of coin, entertainment and e-payment revenues, are driven by i) the service fees we charge consumers for our coin business, ii) the number of entertainment, coin and e-payment machine installations, iii) the frequency of play of our entertainment machines and iv) the size and number of customer transactions for our coin and e-payment services. As a large proportion of our direct operating costs are variable, which allows us to maintain stable operating cash flows while responding to changes in the business, we are able to modulate expenses as revenue fluctuates. Growth Strategy Key elements of our growth strategy include: Leadership of the 4th Wall. There is an area between the cash registers and the front door of retail locations that we call the 4th Wall, where many convenient and profitable consumer services are located. We are a leader in providing retailers 4th Wall products and services, which positions us to continue to drive growth through the front of the store and differentiates us from other suppliers. Our 4th Wall strategy has been the focus of our business development and acquisition strategy and will continue to drive our growth as we move forward. Product and service expansion. In recent years, we have transitioned from a one-product company offering coin-counting services to a business with a variety of products and services for the 4th Wall. We now offer coin counting, entertainment services and e-payment services, as well as self-service DVD rentals. Through our recent acquisition of CMT, we have also broadened our e-payment product line by adding money transfer. Further, our Coin to Card™ program, where consumers receive stored value cards or e-certificates instead of vouchers from our coin machines, is an example of how we are leveraging our coin-counting network to drive incremental transactions. We expect to continue to add products and services to our existing kiosk businesses through our strategic alliances, product line extensions and acquisitions to drive traffic to the 4th Wall. Place more units. We expect continued growth by placing more units into new channels as well as through cross-selling to existing retailers. At December 31, 2006, we had more than 60,000 retail locations representing a variety of channels including supermarkets, mass merchants, drug stores, convenience stores, truck stops, and restaurants. In 2006 we introduced a new design of our coin-counting machines specifically intended for the financial institution market, and we expect to grow this new channel in the coming year. This channel is a natural extension for our coin-counting business and is another channel for consumers to adopt our service. With our vast distribution network, we also continue to focus on cross-selling opportunities. We believe that our combined coin, e-payment and entertainment sales teams and our 4th Wall product portfolio positions us to see continued results from our cross-selling efforts. Stronger retailer relationships. We continue strengthening existing and building new relationships with retailers through our 4th Wall category management program which includes inventory control, management of card sourcing, display design and merchandising and technology integration for point of sale. We believe our program and expertise sets us apart from other suppliers at the front end of the store. Our 4th Wall strategy gives us the ability to work closely with our customer base to consolidate and introduce new services, while increasing store profits for the retailer. We believe the front end of retail stores has long been under-utilized and believe our 4th Wall strategy is a competitive advantage that will drive our growth in the retail environment for years to come. International growth. During 2006, we expanded in Canada with our coin services business and in Mexico with our entertainment services. We continue to grow in these regions as well as in the United Kingdom, one of our more established international markets. In addition, our acquisition of CMT, with an agent network in 142 countries, expanded our international presence. In 2007 and beyond, we expect to continue exploring opportunities in countries where we currently have distribution, as well as other countries where we see opportunities for growth.
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Table of ContentsGrow through acquisitions. While we do not intend to actively pursue material acquisitions in the near term, we continue to explore opportunities to acquire companies and assets in order to add complementary products and services to our existing product lines. Financial Information About Segments, Geographic Areas and Seasonality The segment and geographic information required herein is contained in Note 14 to our Consolidated Financial Statements. A discussion of seasonality is included in Item 8, along with other quarterly financial information. Where You Can Get Information We File with the SEC We file with, and furnish to, the Securities and Exchange Commission (“SEC”), reports including annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, as well as amendments thereto. We maintain a website, www.coinstar.com, where we make these reports and related materials available free of charge as soon as reasonably practicable after we electronically deliver such material to the SEC. These materials can be found on our website under: About Us—Investor Relations—SEC Filings. Item 1A. Risk Factors You should carefully consider the following risk factors that may affect our business, financial condition and results of operations. The risks and uncertainties described below are not the only risks we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business. If any of the following risks actually occur, our business could be harmed, the trading price of our common stock could decline and you could lose all or part of your investment. The termination, non-renewal or renegotiation on materially adverse terms of our contracts with one or more of our significant retailers could seriously harm our business, financial condition and results of operations. We derive substantially all of our revenue from two sources: coin-counting machines installed in high-traffic supermarkets and entertainment services machines installed in supermarkets, mass merchandisers, restaurants, bowling centers, truck stops, warehouse clubs and similar locations. The success of our business depends in large part on our ability to maintain contractual relationships with our retailers in profitable locations. Our typical contract term ranges from one to three years and automatically renews until we or the retailer gives notice of termination. Certain contract provisions with our retailers vary, including product and service offerings, the service fees we are committed to pay each retailer, frequency of service, and the ability to cancel the contract upon notice after a certain period of time. We strive to provide direct and indirect benefits to our retailers that are superior to or competitive with other providers or systems (including coin-counting systems which retailers could operate themselves or through a third party) or alternative uses of the floor space that our machines occupy. If we are unable to provide our retailers with adequate benefits, we may be unable to maintain or renew our contractual relationships on acceptable terms causing our business, financial condition and results of operations to suffer. We do a substantial amount of our business with certain retailers. For example, we have significant relationships with Wal-Mart Stores, Inc. and the Kroger Company, which account for approximately 27% and 11% of our consolidated revenue, respectively. Our entertainment services relationship with Wal-Mart is governed by a contract that Wal-Mart may terminate at any time. Cancellation or adverse renegotiation of these relationships could seriously harm our business and reputation. Payment of increased service fees to retailers could negatively affect our business results. We face ongoing pricing pressure from our retailers to increase the service fees we pay to them on coin and entertainment products and services or to make other financial concessions to win or retain business. If we are unable to respond effectively to ongoing pricing pressures, we may fail to win or retain certain accounts. Our fee arrangements are based on our evaluation of unique factors with each retailer, such as total revenue, e-payment
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Table of Contentscapabilities, long-term non-cancelable contracts, installation of our machines and equipment in high-traffic and/or urban or rural locations and new product and service commitments. Together with other factors, an increase in service fees paid or other financial concessions made to our retailers could significantly increase our direct operating expenses in future periods and harm our business. We may be unable to attract new retailers and penetrate new markets and distribution channels. In order to increase our coin-counting, entertainment and e-payment services machine and equipment installations, we need to attract new retailers and develop operational or unit production cost efficiencies that make it feasible for us to penetrate lower density markets or new distribution channels such as banks and credit unions. We may be unable to attract new retailers or drive down costs relating to the manufacture, installation or servicing of coin-counting, entertainment and e-payment services machines to levels that would enable us to operate profitably in lower density markets or penetrate new distribution channels. If we are unable to do so, our future operating results could be adversely affected. Our strategy to cross-sell our products and services to retailers may be unsuccessful. An important part of our 4th Wall solution is based on cross-selling our selection of products and services to our retailers. We may be unsuccessful in expanding our relationships with retailers to include additional products and services in their storefronts, due to, among other things, failure to negotiate contracts for additional products and services on acceptable terms, other parties providing similar products and services on more favorable terms, or reluctance by retailers to obtain these historically separate product and service categories from a single provider. If we are unable to effectively implement our cross-selling strategy, our business could be negatively impacted. We may be unable to identify and define product and service trends or anticipate, gauge and react to changing consumer demands in a timely manner. To be competitive, we need to develop new products and services that are accepted by the market and establish third-party relationships necessary to develop and commercialize such products and services. For example, toy and other products dispensed in our entertainment services machines must appeal to a broad range of consumers whose preferences cannot be predicted with certainty and are subject to change. If we misjudge the market for our products and services, we may be faced with significant excess inventories for some products, such as toys and other entertainment products, and missed opportunities for sales of other products and services. Further, in order to develop and commercialize new non-entertainment products and services, including our money transfer business, we will need to enhance the capabilities of our coin-counting machines and e-payment machines and equipment, as well as our related network and systems through appropriate technological solutions, and establish market acceptance of such products or services. We cannot assure you that new products or services that we attempt to commercialize will be successful. We may be unable to achieve the strategic and financial objectives for our entry into and our expansion of our entertainment services, and our failure to do so could materially and adversely affect our business, operating results and financial condition. We entered the entertainment services market as a result of our acquisition of ACMI in July 2004, and have since expanded this line of business through other acquisitions, including Amusement Factory in 2005. Our entertainment services now represents our largest source of revenue. There are a number of financial and operational risks associated with this line of business. For example,
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For these and other reasons, we may be unable to achieve the strategic and financial objectives for our entry into and the expansion of our entertainment services business. Our failure to do so could materially and adversely affect our business, operating results and financial condition. Competitive pressures could seriously harm our business, financial condition and results of operations. Our coin-counting services faces competition from supermarkets, banks and other companies that purchase and operate coin-counting equipment from companies such as ScanCoin AB, Cummins-Allison Corporation and others. Our retailers may choose to replace our coin-counting machines with competitor machines and operate such machines themselves or through a third party. In addition, retailers, some of which have significantly more resources than us, may decide to enter the coin-counting market. Some banks and other competitors already provide coin-counting free of charge or for an amount that yields very low margins or that may not generate a profit at all. An expansion of the coin-counting services provided by any of these competitors could materially and adversely affect our business and results of operations. Our entertainment services faces competition from a number of regional and local operators of entertainment services equipment. Many of these competitors are engaged in expansion programs, and we experience intense competition for locations. Our entertainment services equipment also competes with other vending machines, coin-operated entertainment devices, and seasonal and bulk merchandise for sites within retail locations. We may be unable to maintain current sites in retail locations or to obtain new sites in the future on attractive terms or at all. It is possible that a well-financed vending machine manufacturer or other vending machine operator with existing relationships with our retailers could compete with us in certain markets or capture additional market share at our expense. Our e-payment services, including our prepaid wireless and long distance accounts, stored value cards, debit cards, payroll services and money transfer services, faces competition from a variety of types of providers, including, among others, national distributors of similar cards, other retailers who provide these services themselves, as well as money transfer companies. Many of these providers are more established in selling their e-payment services than we are and many invest more resources in providing such services to customers. In addition, in order for us to provide many of our e-payment services, we depend on relationships with third parties, such as national wireless carriers, national supermarket chains and other retailers and financial institutions. Accordingly, if we are unable to effectively market our e-payment services or maintain and establish successful relationships with appropriate third parties, our e-payment services will not be competitive. In addition, the nature and extent of consolidation in markets where we install our machines and equipment, particularly the supermarket and other retailing industries, could adversely affect our operations, including our competitive position, as the number of our machine and equipment installations could be significantly reduced. We may be unable to adequately protect or enforce our patents and other proprietary rights. Our success depends, in part, on our ability to protect our intellectual property and maintain the proprietary nature of our technology through a combination of patents, licenses and other intellectual property arrangements, without infringing the proprietary rights of third parties. We have over 70 United States and international patents related to aspects of self-service coin-counting, including patents regarding machine networking, fraud avoidance and voucher authentication. We also have additional patent applications pending in the United States and several
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Table of Contentsforeign jurisdictions directed to our coin-counting, entertainment and e-payment technologies. In addition, we may apply for or obtain (through development, acquisition or otherwise) additional patents regarding technologies used in our business. Our patents may not be held valid if challenged, our patent applications may not be issued, and other parties may claim rights in or ownership of our patents and other proprietary rights. Since many patent applications in the United States are not publicly disclosed until the patent is issued, others may have filed applications, which, if issued as patents, could cover our products or technology. Patents issued to us may be circumvented or fail to provide adequate protection of our technologies. Our competitors might independently develop or patent technologies that are substantially equivalent or superior to our technologies. Further, since patent terms are limited, other parties may begin practicing our patented technologies when our related patents expire. In addition, certain parties may assert claims of patent infringement or misappropriation against us based on current or pending United States or foreign patents, copyrights or trade secrets, or contracts. If such claims were successful, our business could be harmed. Defending our company and our retailers against these types of claims, regardless of their merits, could require us to incur substantial costs and divert the attention of key personnel. Parties making these types of claims may be able to obtain injunctive or other equitable relief, which could effectively block or impair our ability to provide our coin-counting, entertainment or e-payment services, in the United States or abroad. Such claims could also result in an award of substantial damages. If third parties have or obtain proprietary rights that our products infringe, we may be unable to obtain necessary licenses from others at a reasonable cost or at all. For example, we have from time to time engaged in discussions with a former supplier, ScanCoin AB, in an effort to clarify certain contract rights and obligations as well as ownership of certain of our intellectual property. In addition, if we instigate litigation to enforce our patents or protect our other proprietary rights, or to determine the validity and scope of other parties’ proprietary rights, such litigation could cause us to spend significant financial and management resources. For example, we instigated litigation against Coin X Change, LLC, on May 2, 2006, for infringement of four of our patents relating to our coin-counting technology. We also rely on trademarks, copyrights, trade secrets and other intellectual property to develop and maintain our competitive position. Although we protect our intellectual property in part by confidentiality agreements with our employees, consultants, vendors and corporate partners, these parties may breach these agreements. We may have inadequate remedies for any such breach and our trade secrets may otherwise become known or be discovered independently by our competitors. The failure to protect our intellectual property rights effectively or to avoid infringing the intellectual property rights of others, as well as unfavorable rulings or settlements, could seriously harm our business, financial condition and results of operations. We have substantial indebtedness. On July 7, 2004, we entered into a senior secured credit facility to finance our acquisition of ACMI. The credit facility consists of a $60.0 million revolving credit facility and a $250.0 million term loan facility, of which $187.0 million is outstanding. The credit facility bears interest at variable rates pegged to prevailing interest rates. As a result, our operating results are exposed to risks of fluctuations in interest rates. Loans made pursuant to the credit facility are secured by a first security interest in substantially all of our assets and the assets of our subsidiaries, as well as a pledge of our subsidiaries’ capital stock. The credit facility matures on July 7, 2011. This credit facility may limit our ability to obtain future financings or may negatively impact our business, financial condition, results of operations and growth. Due to substantial financial leverage, we may not be able to generate sufficient cash flow to service the indebtedness, or to adequately fund our operations. Moreover, the credit facility contains negative covenants and restrictions relating to such things as certain common stock repurchases, liens, investments, capital expenditures, indebtedness, cash payments of dividends, and fundamental changes or dispositions of our assets that could impair our flexibility to pursue growth opportunities. In addition, the credit facility requires that we meet certain financial covenants, ratios and tests, including maintaining a
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Table of Contentsmaximum consolidated leverage ratio and a minimum interest coverage ratio, all as defined in the credit facility. If the covenants are not met, our lenders would be entitled, under certain circumstances, to declare our indebtedness immediately due and payable. Defects, failures or security breaches in and inadequate upgrade of our operating systems could harm our business. The operation of our coin-counting machines and e-payment equipment depends on sophisticated software, computer networking and communication services that may contain undetected errors or may be subject to failures. These errors may arise particularly when new or enhanced products or services are added. We have in the past experienced limited delays and disruptions resulting from upgrading or improving our operating systems. Future upgrades or improvements that may be necessary to expand and maintain our business could result in delays or disruptions that could seriously harm our operations. In addition, we outsource to third-party providers certain aspects of our operating systems, including our long-distance telecommunications network. Accordingly, the effectiveness of our operating systems is to a certain degree dependent on the actions and decisions of our third-party providers. Further, while we have taken significant steps to protect the security of our operating systems, security breaches may result from intentional or unintentional acts of third parties, computer viruses or natural disasters, which are beyond our control. Any service disruptions, whether due to errors or delays in or failure to adequately upgrade our software or computing systems, interruptions or breaches in the communications network, or security breaches of the computer network system, caused by us or third parties, could seriously harm our business, financial condition and results of operations. Failure to adequately comply with information security policies or to safeguard against breaches of such policies could adversely affect our operations and could damage our business, reputation, financial position and results of operations. As our business expands to provide new products and services, including additional e-payment services, we are increasing the amount of consumer data that we collect, transfer and retain as part of our business. These activities are subject to laws and regulations, as well as industry standards, in the United States and other jurisdictions in which our products and services are available. These requirements, which often differ materially and sometimes conflict among the many jurisdictions in which we operate, are designed to protect the privacy of consumers’ personal information and to prevent that information from being inappropriately disclosed. We maintain and review technical and operational safeguards designed to comply with applicable legal requirements and industry standards, such as the Payment Card Industry (PCI) guidelines. However, despite those safeguards, it is possible that hackers, employees acting contrary to our policies, third-party agents or others could improperly access our systems or improperly obtain or disclose data about our customers. Any breach of our security policies or applicable legal requirements that compromises consumer data could expose us to regulatory enforcement actions, limit our ability to provide our products and services, subject us to litigation and damage our reputation. Lack of consumer confidence, whether real or perceived, in our coin-counting machines could harm our business. The accuracy of the coin-counting functionality of our machines is important to consumers and our retailers. The failure to maintain consumer confidence in our technology and systems could harm our business. Our inability to collect the data from our coin-counting machines could lead to a delay in processing coins and crediting the accounts of our retailers for vouchers that have already been redeemed. Any loss or delay in collecting or processing coin data could seriously harm our operations. Our future operating results may fluctuate. Our future operating results will depend significantly on our ability to continue to drive new and repeat consumer utilization of our coin-counting, entertainment and e-payment products and services, our ability to
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Table of Contentsdevelop and commercialize new products and services and the costs incurred to do so, and our ability to successfully integrate new lines of business into our operations, including, for example, money transfer services. Our operating results have a history of fluctuating and may continue to fluctuate based upon many factors, including:
In addition, we have historically experienced seasonality in our coin services revenue, with highest revenues experienced in the third calendar quarter, followed by the fourth calendar quarter, and relatively lower revenues in the first half of the year. Our entertainment services revenue has also experienced seasonality, with peak revenues in the fourth quarter and periods surrounding the Easter holiday season. Although our entertainment services revenue may offset the historical seasonality of the coin services revenue to some degree, we expect our results of operations will continue to fluctuate both as a result of seasonal fluctuations and our revenue mix between relatively higher margin coin and e-payment services and relatively lower margin entertainment services. We depend upon third-party manufacturers, suppliers and service providers for key components and substantial support for our coin-counting, entertainment and e-payment services machines and equipment. We conduct limited manufacturing operations and depend on outside parties to manufacture key components of our coin-counting, entertainment and e-payment services machines and equipment. We intend to continue to expand our installed base for coin-counting and e-payment machines in North America and in the United Kingdom and for entertainment services equipment in the United States and Mexico. Such expansion may be limited by the manufacturing capacity of our third-party manufacturers and suppliers. Third-party manufacturers may not be able to meet our manufacturing needs in a satisfactory and timely manner. If there is
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Table of Contentsan unanticipated increase in demand for coin-counting or e-payment machine or entertainment services equipment installations, we may be unable to meet such demand due to manufacturing constraints. Some key hardware components used in the coin-counting and e-payment machines and entertainment services equipment are obtained from a limited number of suppliers. We may be unable to continue to obtain an adequate supply of these components in a timely manner or, if necessary, from alternative sources. If we are unable to obtain sufficient quantities of components or to locate alternative sources of supply on a timely basis, we may experience delays in installing or maintaining coin-counting and e-payment machines or entertainment services equipment, any of which could seriously harm our business, financial condition and results of operations. In addition, we rely on third-party service providers for substantial support and service efforts that we currently do not provide directly. In particular, we contract with third-party providers to arrange for pick-up, processing and deposit of coins as well as limited servicing of our machines. We generally contract with a single transportation provider and coin processor to service a particular region and either party generally can terminate the contracts with advance notice ranging from 30 to 90 days. We do not currently have, nor do we expect to have in the foreseeable future, the internal capability to provide back-up coin processing service in the event of a sudden disruption in service from a commercial coin processor. Any failure by us to maintain our existing coin processing relationships or to establish new relationships on a timely basis or on acceptable terms could harm our business, financial condition and results of operations. We are subject to substantial federal, state, local and foreign laws and government regulation specific to our business. Our business is subject to federal, state, local and foreign laws and government regulation relating to coins, toy safety, child protection, vehicle safety, access to machines in public places, charitable fundraising, the transfer of money or things of value, currency controls, weights and measures, payment instruments, gaming, sweepstakes, contests, consumer protection, consumer privacy, data protection and information security. The application of existing laws and regulations, changes in or enactment of new laws and regulations that apply or may in the future apply to our current or future products or services, changes in governmental authorities’ interpretation of the application of various government regulations to our business, or the failure or inability to gain and retain required permits and approvals could materially and adversely affect our business. In addition, many jurisdictions require us to obtain certain licenses in connection with the operations of our coin-counting, entertainment and e-payment services. For example, in Washington state, skill-crane machines are subject to the licensing requirements of the Washington State Gambling Commission. Further, we are currently applying for licenses in those states and the District of Columbia which require licenses with regard to provision of some of our e-payment services, including stored value card and money transfer transactions. There can be no assurance that we will be granted all necessary licenses in the future or that current licenses will be renewed. Given the unique nature of our business and new products and services we may develop or acquire in the future, the application of various laws and regulations to our business is uncertain. Further, as governmental and regulatory scrutiny and action with regard to many aspects of our business increase, we expect that our costs of complying with the applicable legal requirements will increase, perhaps substantially. Failure to comply with these laws and regulations could result in, among other things, revocation of required licenses, loss of approved status, termination of contracts, administrative enforcement actions and fines, class action lawsuits, cease and desist orders and civil and criminal liability. The occurrence of one or more of these events, as well as the increased cost of compliance, could materially adversely affect our business, financial condition and results of operations. There are risks associated with conducting our business and sourcing goods internationally. We currently have coin operations in Canada and the United Kingdom. We also have entertainment services equipment operating in Mexico. We expect to continue increasing our deployment of both coin-counting and
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Table of Contentse-payment machines and entertainment services equipment internationally. In addition, our money transfer services are offered in over 142 countries, and we expect to continue expanding that area of our business over time. Accordingly, political uncertainties, civil unrest, exchange rate fluctuations, restrictions on the repatriation of funds, adverse changes in tax, tariff and trade regulations, difficulties with foreign distributors and other difficulties in managing an organization outside the United States could seriously harm the development of our business and ability to operate profitably. Further, as we do business with an increasing number of countries, our business becomes more exposed to the impact of the political and economic uncertainties, including government oversight, of foreign jurisdictions. For example, substantially all of the plush toys and other products dispensed from our entertainment services machines are produced by foreign manufacturers, including a majority purchased directly from manufacturers in China. Further, we purchase other vending products from vendors that obtain a significant percentage of such products from foreign manufacturers. As a result, we are subject to changes in governmental policies, exchange rate fluctuations, the imposition of tariffs, import and export controls, transportation delays and interruptions and political and economic disruptions which could disrupt the supply and timely delivery of products manufactured abroad. In addition, we could be affected by labor strikes in the sea shipping, trucking and railroad industries. A reduction or interruption in supplies or a significant increase in the price of one or more supplies could have a material adverse effect on our business. We may be unable to successfully integrate our acquisition of CMT into our operations, which, among other things, requires us to meet additional federal, state, local and foreign laws and government regulations. On May 31, 2006, we acquired CMT, a company that is in the business of offering money transfer services. In connection with the acquisition of CMT, we entered into a Transitional Services Agreement (“TSA”) with Travelex Limited (“Travelex”), the seller of CMT. Under the TSA, affiliates of Travelex will continue to operate the money transfer services business in certain jurisdictions, including the United States, until May 31, 2007 or until we obtain any required licenses or approvals in those jurisdictions and the business is transferred to us. Although we are in the process of applying for these licenses, there is no assurance that we will receive all of the required licenses or approvals before May 31, 2007 or thereafter, or that the money transfer services business can be transferred to us in certain jurisdictions, including in the United States. The money transfer industry is heavily regulated, both in the United States and internationally. Travelex and its affiliates are responsible for legal compliance and related risks with respect to the money transfer services business in the United States and certain other jurisdictions under the TSA until the business in those jurisdictions is transferred. If Travelex or its affiliates or its or their employees violate a legal requirement in any of these jurisdictions where they are responsible for legal compliance, including a United States state or federal law or regulation applicable to the money transfer services business, such a violation may delay or preclude the transfer of the business in that jurisdiction to us, or the violation may increase our costs of transferring the business or operating the business after the transfer. As the money transfer services business in the United States is transferred to us, we are becoming increasingly responsible for compliance with a variety of state laws and regulations, including licensing requirements, applicable to the business. In addition, we are becoming increasingly subject to United States federal anti-money laundering laws, including United States Department of the Treasury registration requirements, and the requirements of the Office of Foreign Assets Control, which prohibit transmitting money to specified countries or to or on behalf of prohibited individuals or entities. If we were to transmit money to or on behalf of, or otherwise conduct business with, a prohibited individual or entity, we could be required to pay significant damages, including fines and penalties. The USA PATRIOT Act mandates several anti-money laundering requirements. Any violation of anti-money laundering laws could lead to significant penalties, and could limit our ability to conduct business in the United States and other jurisdictions.
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Table of ContentsIn addition, the money transfer industry is subject to international regulation, which varies from country to country. In certain countries in which we operate, we are required to maintain licenses or other governmental approvals in order to operate this business. As described above, we will be responsible for compliance with these laws and regulatory requirements in those countries subject to the TSA when the money transfer services business in those countries has transferred. Although most countries in which we operate or will operate this business do not regulate this business to the same degree as the United States, this could change in the future. Failure to comply with the laws and government regulations in jurisdictions in which we operate the money transfer services business could result in, among other things, revocation of required licenses or registrations, loss of approved status, termination of contracts with banks or retail representatives, administrative enforcement actions and fines, penalties or other damages, class action lawsuits, cease and desist orders, and/or other civil and criminal liability. The occurrence of one or more of these events could adversely affect our business, financial condition and results of operations. Furthermore, additions to or changes in the laws, regulations or other industry practices and standards in the United States or any of the foreign countries in which the money transfer services business operates could also increase our compliance and other costs of doing business, require significant systems redevelopment, reduce the market for or value of our products or services or render our products or services less profitable or obsolete, lead to a loss of agents, and have an adverse effect on our results of operations. Our money transfer service is and will remain reliant on an effective agent network. Substantially all of the money transfer services revenue is generated through an agent network spanning 142 countries. Agents include banks and other financial institutions, regional micro-finance companies, chain stores and local convenience stores. Transaction volumes at existing agent locations often increase over time and new agents provide us with additional revenue. If agents decide to leave our network, or if we are unable to sign new agents, our revenue and profit growth rates may be adversely affected. Agent attrition might occur for a number of reasons, including a competitor engaging an agent or an agent’s dissatisfaction with its relationship with us or the revenue derived from that relationship. In addition, agents may generate fewer transactions or less revenue for various reasons, including the appearance of competitors close to our agent locations or increased competition. Because an agent is a third party that engages in a variety of activities in addition to providing our services, an agent may encounter business difficulties unrelated to its provision of our services, which could cause the agent to reduce its number of locations, hours of operation, or cease doing business altogether. The failure of the agent network to meet our expectations regarding revenue production and business efficiencies may negatively impact our business, financial condition and results of operations. Further, failure, either intentional or unintentional, by our agents to comply with the laws and regulatory requirements of applicable jurisdictions, including anti-money laundering, consumer privacy and information security restrictions, could result in, among other things, revocation of required licenses or registrations, loss of approved status, termination of contracts with third parties, administrative enforcement actions and fines, class action lawsuits, cease and desist orders and civil and criminal liability, as well as damage to our reputation. The occurrence of one or more of these events could materially adversely affect our business, financial condition and results of operations. Our money transfer services may involve the movement of large sums of money, and, as a result, our business is particularly dependent on our ability to process and settle transactions accurately and efficiently. Our money transfer services involves the movement of large sums of money. Money transfer services revenues consist primarily of transaction fees that are charged for the movement of money. These transaction fees represent only a small fraction of the total amount of money that is moved. Because we are responsible for large sums of money that are substantially greater than the revenues generated, the success of this business particularly depends upon the efficient and error-free handling of the money that is remitted and that is used to clear payment instruments or complete money transfers. We rely on the ability of our agents and employees and our operating systems and network to process these transactions in an efficient, uninterrupted and error-free
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Table of Contentsmanner. In addition, we rely on third-party vendors in our business, including clearing banks which clear our money orders and official checks and certain of our telecommunications providers. In the event of a breakdown, catastrophic event, security breach, improper operation or any other event impacting our systems or network or our vendors’ systems or processes, or improper action by our agents, employees, or third party vendors, we could suffer financial loss, loss of customers, regulatory sanctions and damage to our reputation. Higher petroleum prices may adversely affect our operating results and reduce our profitability. We purchase a substantial amount of goods overseas, particularly plush toys and other products dispensed from our entertainment services machines, resulting in significant transportation-related costs. Petroleum-based resins are used in the manufacture of these products. In addition, we operate a large number of vehicles used by our field service personnel for the purpose of servicing and maintaining our coin-counting, entertainment and e-payment services machines. Significant increases in petroleum prices during prior periods have negatively impacted our results of operations. The cost of petroleum is volatile and may increase as a result of natural disasters, political and geopolitical issues or other reasons beyond our control. Further increases in petroleum prices may have an adverse affect on our operating results. Our customers’ ability to access our products and services can be adversely affected by severe weather, natural disasters and other events beyond our control, such as fires, power failures, telecommunications loss and terrorist attacks. Our operational and financial performance is a direct reflection of customer use of and the ability to operate and service the coin-counting, entertainment and e-payment services machines and equipment used in our business. Severe weather, natural disasters and other events beyond our control can, for extended periods of time, significantly reduce customer use of our products and services as well as interrupt our own ability to manufacture, operate and service our machines. In some cases, severe weather, natural disasters and other events beyond our control may result in the total loss of machines used to provide our products and services, which losses may not be fully covered by insurance. For example, hurricanes in the gulf coast region of the United States in 2005 caused damage and operational interruptions to some of the retail and other locations where our machines are installed. Acquisitions and investments involve risks that could harm our business and impair our ability to realize potential benefits from such acquisitions and investments. As part of our business strategy, we have in the past sought and may in the future seek to acquire or invest in businesses, products or technologies that we feel could complement or expand our business. For example, in December 2005, we made an investment to acquire a 47.3% interest in Redbox, a provider of self-service DVD kiosks, with the ability under certain circumstances to obtain a majority interest, and in May 2006, we purchased the money transfer services business as described above. However, we may be unable to adequately address the financial, legal and operational risks raised by such acquisitions or investments, which could harm our business and prevent us from realizing the projected benefits of the acquisitions and investments. Further, the evaluation and negotiation of potential acquisitions and investments, as well as the integration of an acquired business, will divert management time and other resources. In addition, we cannot assure you that any particular transaction, even if successfully completed, will ultimately benefit our business. Certain financial and operational risks related to acquisitions and investments that may have a material impact on our business are:
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Recall of any of the products dispensed by our entertainment services machines or by the entertainment services industry generally could adversely affect our entertainment services business. Our entertainment services machines, and the entertainment services industry generally, are subject to regulation by the Consumer Product Safety Commission and similar state and international regulatory authorities. The toys and other products dispensed from our entertainment services machines could be subject to involuntary recalls and other actions by regulatory authorities. Concerns about product safety may lead us to voluntarily recall or discontinue offering selected products. Defects in any of our products distributed through our entertainment services machines could result in the rejection of our entertainment services products by consumers, damage to our reputation, lost sales, potential inventory valuation write-downs, excess inventory, diverted development resources and increased customer service and support costs, any of which could harm our business. Any such errors, defects or recalls may not be covered by insurance or cause our insurance costs to increase in future periods. We may be subject to product liability claims if property or people are harmed by our products and services. Some of the products we sell, especially through our entertainment services machines, may expose us to product liability claims arising from personal injury, death or property damage. Any such product liability claim may result in adverse publicity regarding us, our entertainment service machines and the products we sell. Even if we successfully defend ourselves against this type of claim, we could be forced to spend a substantial amount of money in litigation expenses and our management could be required to spend valuable time in defending against these claims. Our vendors may not indemnify us against product liability. There is a risk that such claims or liabilities may exceed, or fall outside the scope of, our insurance coverage and we cannot be certain that insurance will continue to be available to us on economically reasonable terms, or at all. Any imposition of product liability could harm our business, financial condition and operating results. Litigation, regulatory actions or investigations could result in material rulings, settlements, fines, penalties or publicity that could adversely affect our business, financial condition and results of operations. Our business has in the past been, and may in the future continue to be, the subject of class actions, regulatory actions, investigations and other litigation. The outcome of class action lawsuits, regulatory actions, investigations or other litigation is often difficult to assess or quantify. Plaintiffs or regulatory bodies may seek recovery of very large or indeterminate amounts of money or substantial restrictions on our business activities, and the results, including the magnitude, of lawsuits, actions and investigations may remain unknown for substantial periods of time. The cost to settle or defend lawsuits, regulatory actions, investigations or other litigation may be significant. For example, we recorded a $1.6 million charge for the proposed settlement of a recently filed lawsuit alleging wage and hour violations under the California labor code. We believe the lawsuit originated primarily from employment practices of acquired entertainment companies prior to us buying them. In addition, there may be adverse publicity associated with such legal developments that could decrease customer acceptance of our products and services. As a result, litigation, regulatory actions or investigations involving us or are affiliates may adversely affect our business, financial condition and results of operations.
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Table of ContentsOur stock price has been and may continue to be volatile. Our stock price has fluctuated substantially since our initial public offering in July 1997. For example, during the twelve months ended February 16, 2007, the sale price of our common stock ranged from $21.60 to $34.40 per share. Our stock price may fluctuate significantly in response to a number of factors, including:
In addition, the securities markets have experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. These market fluctuations may also seriously harm the market price of our common stock. If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial condition and results or prevent fraud. Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent or detect fraud. Inherent in our business, which is primarily cash driven, is the risk of theft and fraud. Any inability to provide reliable financial reports or prevent or detect fraud could harm our business. We continue to evaluate our internal control procedures to satisfy the requirements of the Sarbanes-Oxley Act of 2002, which requires management and our auditors to evaluate and assess the effectiveness of our internal controls. If we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we could be subject to regulatory scrutiny, civil or criminal penalties or stockholder litigation. In addition, failure to maintain adequate internal controls could result in financial statements that do not accurately reflect our financial condition or results. Our anti-takeover mechanisms may affect the price of our common stock and make it harder for a third party to acquire us without the consent of our board of directors. We have implemented anti-takeover provisions that may discourage takeover attempts and depress the market price of our stock. Provisions in our certificate of incorporation, bylaws and rights plan could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. Delaware law also imposes some restrictions on mergers and other business combinations between us and any acquirer of 15% or more of our outstanding common stock. Furthermore, Washington law may impose additional restrictions on mergers and other business combinations between us and any acquirer of 10% or more of our outstanding common stock. These provisions may make it harder for a third party to acquire us without the consent of our board of directors, even if the offer from a third party may be considered beneficial by some stockholders.
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Table of ContentsItem 2. Properties. We are headquartered in Bellevue, Washington, where we maintain most of our sales, marketing, research and development, quality control, customer service operations and administration. In addition, our main entertainment services office is located in Louisville, Colorado. Our corporate administrative, marketing and product development facility is located in a 46,070 square foot facility in Bellevue, Washington, under a lease that expires December 1, 2009. Our entertainment services office is located in a 31,000 square foot facility in Louisville, Colorado, which is utilized for administrative, warehouse, pre-pack and field office functions. The lease for this facility expires on February 28, 2013. Item 3. Legal Proceedings. We are subject to various legal proceedings and claims arising in the ordinary course of business. Our management does not expect that the results in any of these legal proceedings would have a material adverse effect on our financial position, results of operations or cash flows. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of security holders during the fourth quarter of 2006.
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Table of ContentsItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. Market Information Our common stock is traded on the NASDAQ Global Select Market under the symbol “CSTR.” The following table sets forth the high and low bid prices per share as reported by the NASDAQ Global Select Market for our common stock for each quarter during the last two fiscal years. The quotations represent inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions.
The last reported sale price of our common stock on the NASDAQ Global Select Market on February 16, 2007 was $29.37 per share. Holders As of February 16, 2007, there were 141 holders of record of our common stock. This does not include the number of persons whose stock is in nominee or “street name” accounts through brokers. Dividends We have never paid any cash dividends on our capital stock. We currently intend to retain all future earnings to fund development and growth of our business, retire debt obligations or buy back our common stock for the foreseeable future. In addition, we are restricted from paying dividends under our current credit facility. Recent Sales of Unregistered Securities We did not sell any unregistered securities during our fiscal year ended December 31, 2006. Securities Authorized for Issuance Under Equity Compensation Plans See Item 12, which incorporates by reference to the Proxy Statement relating to our 2007 Annual Meeting of Stockholders, the information concerning securities authorized for issuance under our equity compensation plans.
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Table of ContentsItem 6. Selected Consolidated Financial Data. The following selected financial data is qualified by reference to, and should be read in conjunction with, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements of Coinstar, Inc. and related Notes thereto included elsewhere in this Annual Report on Form 10-K.
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Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and related Notes thereto included elsewhere in this Annual Report on Form 10-K. Except for the consolidated historical information, the following discussion contains forward-looking statements. Actual results could differ from those projected in the forward-looking statements. Please refer to “Special Note Regarding Forward-Looking Statements” at the beginning of this annual report. Overview Business We are a multi-national company offering a range of 4th Wall solutions for retailers’ storefronts consisting of self-service coin counting; entertainment services such as skill-crane machines, bulk vending machines and kiddie rides; and e-payment services such as prepaid wireless products, stored value cards, payroll cards, prepaid debit cards and money transfer services. In addition, through our strategic investments in Redbox and DVDXpress, we offer self-service DVD kiosks where consumers can rent or purchase movies. We also offer a range of point-of-sale terminals, stand-alone e-payment kiosks and e-payment enabled coin-counting machines in drugstores, universities, shopping malls, supermarkets and convenience stores in the United States, the United Kingdom and other countries. Coin services We are the leader in the self-service coin-counting services market. We own and operate the only multi-national fully automated network of self-service coin-counting machines across the United States, Canada, Puerto Rico and in the United Kingdom. We estimate that at any one time, there is more than $10.5 billion worth of coin sitting idle in households in the United States. In 2006, consumers processed more than $2.6 billion worth of coin through our coin-counting machines. We own and service all of our coin-counting machines. Consumers feed loose change into the machines, which count the change and then dispense vouchers or, in some cases, issue e-payment products, at the consumer’s election. Each voucher lists the dollar value of coins counted, less our transaction fee, which is typically 8.9% of the value of coins counted. In certain cases when our e-payment product is issued instead of a voucher, the consumer does not pay a fee. We generate revenue through transaction fees from our customers and business partners. We launched our business in North America with the installation of the first Coinstar® coin-counting machine in the early 1990s and in 2001, we began offering our coin services in the United Kingdom. Since inception, our coin-counting machines have counted and processed more than 300 billion coins worth more than $15.5 billion in more than 435 million self-service coin-counting transactions. We own and operate more than 13,500 coin-counting machines in the United States, Canada, Puerto Rico and the United Kingdom (approximately 8,200 of which are e-payment enabled). Entertainment services We are the leading owner and operator of skill-crane and bulk vending machines in the United States. We estimate that the market for our entertainment services is approximately $1.1 billion annually in the United States. Our entertainment services machines consist primarily of skill-crane machines, bulk vending and kiddie rides, which are installed in more than 35,000 retail locations, totaling more than 300,000 pieces of equipment. As with our coin services business, we own and service all of our entertainment services machines, providing a
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Table of Contentsconvenient and trouble free service to retailers. We generate revenue from money deposited in our machines that dispense plush toys, novelties and other items. E-payment services We offer e-payment services, including activating and reloading value on prepaid wireless accounts, selling stored value cards, loading and reloading prepaid debit cards and prepaid phone cards, prepaid phones, providing payroll card services and, with the acquisition of CMT, now offer money transfer services. We believe these and other e-payment services represent a significant growth opportunity for us. We offer various e-payment services in the United States and the United Kingdom through 14,000 point-of-sale terminals, 400 stand-alone e-payment kiosks and 8,200 e-payment-enabled coin-counting machines in supermarkets, drugstores, universities, shopping malls and convenience stores. We have relationships with national wireless carriers, such as Sprint, Verizon, T-Mobile, Virgin Mobile and Cingular Wireless. We generate revenue primarily through commissions or fees charged per e-payment transaction and pay our retailers a fee based on commissions earned on the sales of e-payment services. Strategy Our strategy, embodied in our 4th Wall concept, is based on cross-selling our full range of products and services to our retailers. In addition, we believe that we will continue to increase operating efficiencies by combining and concentrating our products and services in our retailers’ storefront. While the entertainment services market is relatively mature and has experienced slow growth, we believe that we have significant opportunities in combining it with self-service coin counting, e-payment services and DVD kiosks. We expect to continue devoting significant resources to building our sales organization in connection with our 4th Wall cross-selling strategy, adding administrative personnel to support our growing organization and developing the information technology systems and technology infrastructure necessary to support our products and services. We expect to continue evaluating new marketing and promotional programs to increase consumer utilization of our services as well as further expand our product research and development efforts. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to coin-in-machine and accrued expenses, property and equipment, stock-based compensation, income taxes and contingencies. We base our 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. Actual results may differ from these estimates under different assumptions or conditions. Revenue recognition: We recognize revenue as follows:
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Cash and cash equivalents, cash in machine or in transit, and cash being processed: We consider all highly liquid securities purchased with a maturity at purchase of three months or less to be cash equivalents. Cash in machine or in transit represents coin residing in our coin-counting or entertainment services machines, cash being processed by carriers, or cash deposits in transit. Cash being processed represents cash which we are obligated to use to settle our accrued liabilities payable to retailers. We have the contractual right and obligation to pick up and process all coins in our machines, although in certain circumstances, we may not be able to immediately access the coins until they have been deposited into one of our regional bank accounts. Coin-in-machine represents the cash deposited into our entertainment services machines at period end which has not yet been collected. Based on our estimate of coin-in-machine, we have recognized the related revenue, the corresponding reduction to inventory and increase to accrued liabilities which represents the direct operating expenses associated with the coin-in-machine estimate. The estimated value of our entertainment services coin-in-machine was approximately $7.1 million and $5.0 million at December 31, 2006 and 2005, respectively. Inventory: Inventory, which consists primarily of plush toys and other products dispensed from our entertainment services machines, is stated at the lower of cost or market. The cost of inventory includes mainly the cost of materials, and to a lesser extent, labor, overhead and freight. Cost is determined using the average cost method. Inventory, which is considered finished goods, consists of purchased items ready for resale or use in vending operations. Also included in inventory are prepaid airtime, prepaid phones and prepaid phone cards; cost is determined using the first-in-first-out method. Property and equipment: Property and equipment are depreciated in accordance with the methods disclosed in Note 2 to our Consolidated Financial Statements. We are depreciating the cost of our coin-counting and entertainment services machines over periods that range from 3 to 10 years and have determined that these lives are appropriate based on our analysis which included a review of historical data and other relevant factors. We will continue to evaluate the useful life of our coin-counting and entertainment services machines, as well as our other property and equipment as necessary, and will determine the need to make changes when and if appropriate. Any changes to the estimated lives of our machines may cause actual results to differ based on different assumptions or conditions. Purchase price allocations: In connection with our acquisitions of our entertainment and e-payment subsidiaries, we have allocated the respective purchase prices plus transaction costs to the estimated fair values of assets acquired and liabilities assumed. These purchase price allocations were based on our estimates of fair values and estimates from third-party consultants. Adjustments to our purchase price allocation estimates are made based on our final analysis of the fair value during the allocation period, which is within one year of the purchase date. Goodwill and intangible assets: Goodwill represents the excess of cost over the estimated fair value of net assets acquired, which is not being amortized. We test goodwill for impairment at the reporting unit level on an annual or more frequent basis as determined necessary. We determined our reporting units for the purpose of performing our goodwill impairment test as our operating segments, as each is comprised of a single component. Financial Accounting Standards Board (“FASB”) Statement No. 142, Goodwill and Other Intangible Assets (“SFAS 142”) requires a two-step goodwill impairment test whereby the first step, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired and the second test is not performed. The second step of the impairment test is performed when required and
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Table of Contentscompares the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. Based on the annual goodwill test for impairment we performed for the years ended December 31, 2006 and 2005, we determined there was no impairment of our goodwill. Our intangible assets are comprised primarily of retailer relationships acquired in connection with our acquisition of ACMI in 2004, Amusement Factory in 2005, Travelex Money Transfer Limited in 2006 and other smaller acquisitions. We used a third-party consultant, which used expectations of future cash flows to estimate the fair value of the acquired retailer relationships. We amortize our intangible assets on a straight-line basis over their expected useful lives. Fees paid to retailers: Fees paid to retailers relate to the amount we pay our retailers for the benefit of placing our machines in their stores and their agreement to provide certain services on our behalf to our customers. The fee is calculated as a percentage of each coin-counting transaction or as a percentage of our entertainment revenue and is recorded in our consolidated income statement under the caption “direct operating expenses.” The fee arrangements are based on our evaluation of certain factors with the retailers, such as total revenue, e-payment capabilities, long-term non-cancelable contracts, installation of our machines in high traffic and/or urban or rural locations, new product commitments, co-op marketing incentive or other criteria. We recognize this expense at the time we recognize the associated revenue from each of our customer transactions. This expense is recorded on a straight-line basis as a percentage of revenue based on estimated annual volumes. In certain instances, we prepay amounts to our retailers, which are expensed over the contract term. The expense is included in depreciation and other in the accompanying consolidated statements of operations and cash flows. Stock-based compensation: Effective January 1, 2006, we adopted the fair value recognition provisions of FASB Statement No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”) using the modified–prospective transition method. Under this transition method, compensation expense recognized includes the estimated fair value of stock options granted on and subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R, and the estimated fair value of the portion vesting in the period for options granted prior to, but not vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). Prior to January 1, 2006, we followed Accounting Principle Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”) and did not record the compensation expense for the majority of our stock-based compensation awards. Further, in accordance with the modified-prospective transition method, results for prior periods have not been restated. Recent accounting pronouncements: In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (“FIN 48”). This interpretation clarifies the accounting for uncertainty in income taxes by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the effects of FIN 48; however, we do not expect a significant or material impact from adoption. Reclassifications: Certain reclassifications have been made to the prior year balances to conform with the current year presentation.
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Table of ContentsResults of Operations The following table shows revenue and expenses as a percent of revenue for the last three years:
Years Ended December 31, 2006, 2005 and 2004 Revenue Revenues increased year over year to $534.4 million in 2006, from $459.7 million in 2005 and $307.1 million in 2004. Our revenue grew as a result of two primary factors, the acquisition of entertainment and e-payment subsidiaries during 2006, 2005 and 2004 and an increase in coin-counting activity due to a greater number of installed machines, and increased trial and repeat usage. Revenue from our entertainment services was $273.5 million, $239.1 million and $111.1 million, respectively for 2006, 2005 and 2004. Adjusting for the timing of our acquisitions of ACMI in 2004 and Amusement Factory in 2005, entertainment services revenues were relatively flat from 2004 through 2006. We believe this is due to the maturity of this industry as well as lack of increased foot traffic at our retailers’ locations. While we are watching these trends closely, we do not expect a significant change in foot traffic or other factors which could cause revenue to change significantly in the near term. Revenue from our coin and e-payment services increased year over year to $261.0 million in 2006, an 18.3% increase from $220.6 million in 2005, of which $9.0 million of the increase was due to our acquisition of CMT in 2006. Revenues in 2005 increased 12.6% from revenues of $196.0 million in 2004. The total dollar value of coins processed through our network increased to approximately $2.6 billion in 2006 from $2.3 billion in 2005 and $2.2 billion in 2004. Additionally, the total coin-counting machines installed at December 31, 2006, 2005 and 2004 were approximately 13,500, 12,800 and 12,100, respectively. The increase in the number of machines, as well as the increased usage of our existing machines, accounted for the majority of these increases in revenue. Our e-payment prepaid telephony and stored value card sales have increased year over year and we expect this trend to continue. Further, we are currently evaluating price points for our entertainment machines and may consider increasing price points pending the outcome. We expect to continue installing additional coin-counting and e-payment machines and therefore, expect to continue to experience revenue growth in the foreseeable future.
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Table of ContentsExpenses Direct Operating Expenses Direct operating expenses for our 4th Wall product and service offerings consist of expenses associated with our coin-counting, entertainment services and e-payment services operations and support, as follows: For coin-counting services and e-payment services, these expenses consist primarily of the cost of (1) the percentage of transaction fees we pay to our retailers, (2) coin pick-up, transportation and processing expenses and (3) field operations support and related expenses. Variations in the percentage of transaction fees we pay to our retailers may result in increased expenses. Such variations are based on our evaluation of certain factors with the retailer, such as total revenue, e-payment capabilities, long-term non-cancelable contracts, installation of our machines in high traffic and/or urban or rural locations, new product commitments, co-op marketing incentive or other criteria. For entertainment services, these expenses consist primarily of (1) the fees we pay our retailers as commissions and for the placement of machines, (2) the cost of plush toys and other products dispensed from the skill-crane and bulk-vending machines and (3) field operations support and related expenses. Direct operating expenses increased to $355.4 million in 2006, of which $8.5 million was due to our acquisition of CMT and $1.1 million represents the incremental expenses due to the adoption of SFAS 123R, from $309.2 million in 2005 and $186.9 million in 2004. Direct operating expenses further increased due to expenses incurred to support our increased year over year revenues and the acquisitions of our entertainment subsidiaries. The addition of our entertainment companies to our 4th Wall products and services offerings has added inventory and related freight cost to our direct operating expenses, which we do not incur for our coin-counting services. In addition, during the fourth quarter of 2006, we recorded $1.6 million of expense for the proposed settlement of a recently filed lawsuit alleging wage and hour violations under the California labor code. The lawsuit was originated primarily from the employment practices of the acquired entertainment subsidiary prior to the acquisition, of which we made no admission of liability. Direct operating expenses as a percentage of revenue was 66.5% in 2006, 67.2% in 2005 and 60.9% in 2004. We are integrating our various business operations and have realized operating expense efficiencies as a percentage of revenue in 2006. For example, as a result of consolidating our field service routes in 2006, we have begun to improve efficiencies and cost savings in personnel, auto, fuel and related costs which we expect to continue in 2007. Marketing Our marketing expenses consist primarily of marketing, advertising and public relations efforts in existing market regions and startup marketing expenses incurred to launch our services in new regional markets. Marketing expenses increased to $14.4 million in 2006, of which $1.5 million was due to our acquisition of CMT, from $10.7 million in 2005 and $12.9 million in 2004. During 2006, we directed most of our advertising dollars toward national cable broadcasting and magazine advertising. We have been using advertising to introduce e-payment features on our coin-counting machines and other e-payment product channels such as our stored value card offerings. This directed marketing and advertising approach, which we expect to continue in 2007, continues driving increased trial and repeat usage of both our coin services offering and e-payment products. Marketing as a percentage of revenue was 2.7% in 2006, 2.3% in 2005 and 4.2% in 2004. Research and Development Our research and development expenses consist primarily of development costs of our coin-counting machine software, network applications, machine improvements and new product development.
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Table of ContentsResearch and development expenses have remained relatively consistent. Our research and development expenses were $5.2 million in 2006, $5.7 million in 2005 and $5.5 million in 2004. Research and development expenses represent expenditures to support development and design of complementary new product ideas and continue our ongoing efforts to enhance our existing products and services, primarily our coin-counting system. It is our intent to continue to invest in research and development in the coming years. Since revenues have increased significantly and our research and development expenditures remained relatively consistent, research and development as a percentage of revenue has been decreasing to 1.0% in 2006 from 1.2% in 2005 and 1.8% in 2004. General and Administrative Our general and administrative expenses consist primarily of administrative support for field operations, customer service, systems and engineering support, computer network operations, finance, human resources, occupancy expenses, legal expenses and insurance. General and administrative expenses increased to $55.1 million in 2006, of which $3.7 million was due to our acquisition of CMT and $4.0 million represents the incremental expense due to the adoption of SFAS 123R, from $36.6 million in 2005 and $27.5 million in 2004. General and administrative expenses further increased due to the acquisitions of our entertainment subsidiaries and the incremental cost of supporting subsidiary companies with regional offices throughout the United States and in the United Kingdom. Although we expect our general and administrative expenses for stock options and CMT to moderately increase for the foreseeable future, we will continue to strive for additional synergies as a result of efficiencies gained from our integrations. General and administrative expense as a percentage of revenue has increased to 10.3% in 2006 from 8.0% in 2005 and 8.9% in 2004. Depreciation and Other Our depreciation and other expenses consist primarily of depreciation charges on our installed coin-counting and entertainment services machines and depreciation on computer equipment and leased automobiles. Depreciation and other expense increased to $52.8 million in 2006, from $45.3 million in 2005 and $35.3 million in 2004. Depreciation and other expense increased year over year primarily due to our increased installed entertainment machine counts from our acquisitions. Depreciation and other expense as a percentage of revenue was 9.9% in 2006 and 2005, and 11.5% in 2004. Amortization of Intangible Assets Our amortization expense consists of amortization of intangible assets including retailer relationships that were valued in connection with our acquisitions. Amortization of intangible assets increased to $6.2 million in 2006, which $0.9 million was due to our acquisition of CMT, from $4.6 million in 2005 and $2.0 million in 2004. Amortization expense of intangible assets increased due to our acquisitions in 2006, 2005 and 2004. Our intangible assets are mainly composed of the value assigned to acquired retailer relationships and, to a lesser extent, acquired internally developed software from acquisitions. Amortization expense as a percentage of revenue increased to 1.1% in 2006 from 1.0% in 2005 and 0.7% in 2004. Other Income and Expense Interest income and other, net, was $1.5 million in 2006 and 2005 and $0.3 million in 2004. The increase in 2005 from 2004 was the result of interest earned on the cash proceeds of $81.6 million in connection with our common stock offering in December 2004.
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Table of ContentsInterest expense increased to $15.7 million in 2006 from $12.9 million in 2005 and $6.3 million in 2004. The increase is primarily due to higher interest rates. During July 2004 we entered into a $250.0 million term loan facility and $60 million revolving loan facility to finance our acquisition of ACMI. As of December 31, 2006, $187.0 million was outstanding on our term loan. Income Taxes The effective income tax rate was 39.3% in 2006 compared with 39.0% in 2005 and 33.3% in 2004. As illustrated in Note 10 to the consolidated financial statements, the effective income tax rate for 2006 varies from the federal statutory tax rate of 35% primarily due to state income taxes, non-deductible stock-based compensation expense recorded for incentive stock option (“ISO”) awards offset by the benefit arising for ISO disqualifying dispositions, the impact of our election during the third quarter of 2006 of the indefinite reversal criteria for unremitted foreign earnings under APB No. 23, Accounting for Income Taxes—Special Areas (“APB 23”), the impact of adjusting our deferred tax asset associated with state operating loss carryforwards, the impact of recognizing an increase to our available research and development credit, as well as the impact of recognition of a valuation allowance to offsetting foreign deferred tax assets relating to our acquisition of CMT. The effective income tax rates for 2005 and 2004 vary from the federal statutory tax rate of 35% primarily due to state income taxes. In 2004, the rate was also impacted by a reduction to the valuation allowance for our deferred tax assets and the impact of revising the rate used to measure our deferred taxes. As of December 31, 2006 and 2005, our net deferred income tax assets totaled $10.3 million and $22.7 million, respectively. In the years ended December 31, 2006, 2005 and 2004 we recorded $12.1 million, $14.2 million and $10.2 million in income tax expense, respectively, which, as a result of our U.S. net operating loss carryforwards, will not result in cash payments for U.S. federal income taxes other than federal alternative minimum taxes. We have made current tax payments to state and foreign jurisdictions. Liquidity and Capital Resources Cash and Liquidity Our business involves collecting and processing large volumes of cash, most of it in the form of coins. We present three categories of cash on our balance sheet: cash and cash equivalents, cash in machine or in transit, and cash being processed. As of December 31, 2006, we had cash and cash equivalents, cash in machine or in transit, and cash being processed totaling $178.2 million, which consisted of cash and cash equivalents immediately available to fund our operations of $24.7 million, cash in machine or in transit of $63.7 million and cash being processed of $89.7 million. Cash in machine or in transit represents coin residing in our coin-counting or entertainment services machines or being processed by carriers which is not immediately available to us until it has been collected and deposited. Cash being processed represents coin residing in our coin-counting or entertainment services machines or being processed by carriers which we are mainly obligated to use to settle our accrued liabilities payable to our retailer partners. Working capital was $73.1 million at December 31, 2006, compared with $101.2 million at December 31, 2005. The decrease in working capital was primarily the result of the timing of payments to our vendors and retailers. Net cash provided by operating activities was $115.4 million for the year ended December 31, 2006, compared to net cash provided by operating activities of $103.1 million for the year ended December 31, 2005. Cash provided by operating activities increased as a result of an increase in cash provided by our operating assets and liabilities of $5.4 million, mainly due to the timing of payments to our retailers, and an increase in cash provided from a net increase of non-cash transactions on our consolidated income statement of $10.5 million, mostly from increases in depreciation and other expense and amortization of intangible assets acquired from acquisitions. Net cash used by investing activities for the year ended December 31, 2006 was $89.0 million compared to $84.6 million in the prior year period. In 2006 net cash used by investing activities consisted of net equity
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Table of Contentsinvestments of $12.1 million, acquisitions of subsidiaries of $31.3 million and capital expenditures of $45.9 million. Comparatively, in 2005 net cash used by investing activities consisted of net equity investments of $20.3 million, acquisitions of businesses of $20.8 million and net capital expenditures of $43.9 million, mainly to purchase coin-counting and entertainment service machines. Net cash used by financing activities for the year ended December 31, 2006, was $25.8 million compared to net cash provided by financing activities of $1.8 million in the prior year period. In 2006, net cash provided by financing activities represented the proceeds of employee stock option exercises of $5.4 million, offset by cash used to repurchase our common stock of $8.0 million, cash used to make principal payments on debt of $24.2 million, including a $16.9 million mandatory paydown under the terms of our credit facility, and the excess tax benefit from exercise of stock options of $1.0 million. In 2005 net cash provided by financing activities were the proceeds of employee stock option exercises of $5.5 million, offset by cash used to make principal payments on debt of $3.8 million. In 2004, we refinanced an existing credit facility by retiring $7.8 million of outstanding debt with funds provided by drawing $250.0 million from a new credit facility. We used most of the borrowings to purchase ACMI. Additionally, in December 2004 we received proceeds of $81.6 million offset by $0.5 million of financing fees from a secondary offering of our common stock and used some of the proceeds to retire $41.0 million of our long-term debt and we received $7.3 million from the proceeds of employee stock option exercises. Equity Investments On December 1, 2005, we invested $20.0 million to obtain a 47.3% interest in Redbox. We are accounting for our ownership under the equity method in our consolidated financial statements. Our 47.3% interest in this investment included a conditional consideration agreement requiring us to contribute an additional $12.0 million if Redbox achieved certain targets within a one year period. In December 2006, those targets were met and we paid the conditional consideration of $12.0 million; however, the percentage of our interest in Redbox did not change. We have a one-time option to purchase shares at any time between December 31, 2007, and December 31, 2008, which could increase our ownership interest in Redbox up to 51%. On August 5, 2005, we entered into a credit agreement to provide DVDXpress with a $4.5 million credit facility. On July 28, 2006, the credit agreement was amended to incrementally increase the credit commitment amount up to $7.3 million at set measurement dates extending through July 1, 2007. Loans made pursuant to the credit facility are secured by a first security interest in substantially all of DVDXpress’ assets as well as a pledge of their capital stock. Interest on the unpaid balance of the loan is based on an annual rate equal to LIBOR plus three percent. As of December 31, 2006, DVDXpress has drawn down $5.5 million on this credit facility. On December 7, 2005, we signed an asset purchase option agreement that allows us to purchase substantially all of DVDXpress’ business assets and liabilities in exchange for any outstanding debt and accrued interest on the credit facility plus $10,000 and contingent consideration of up to $3.5 million based on achievement of specific conditions. Effective December 7, 2005, we have consolidated the fair value of DVDXpress’ financial results into our consolidated financial statements in accordance with FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities (“FIN 46R”). Credit Facility On July 7, 2004, we entered into a senior secured credit facility. This facility provided for advances totaling up to $310.0 million, consisting of a $60.0 million revolving credit facility and a $250.0 million term loan facility. Fees for this facility of approximately $5.7 million are being amortized over the life of the revolving line of credit and the term loan which are 5 years and 7 years, respectively. Loans under this facility are secured by a first security interest in substantially all of our assets and the assets of our subsidiaries, as well as a pledge of our subsidiaries’ capital stock. The credit facility matures on July 7, 2011. As of December 31, 2006, our original term loan balance of $250.0 million had been reduced to $187.0 million and, to date, we have not borrowed on our revolving credit facility.
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Table of ContentsAdvances under this credit facility may be made as either base rate loans (the higher of the Prime Rate or Federal Funds Effective Rate) or LIBOR rate loans at our election. Applicable interest rates are based upon either the LIBOR or base rate plus an applicable margin dependent upon a consolidated leverage ratio of outstanding indebtedness to EBITDA (to be calculated in accordance with the terms specified in the credit agreement). Our consolidated leverage ratios are based upon either LIBOR plus 200 basis points or the base rate plus 100 basis points. At December 31, 2006, our interest rate on this facility was 7.4%. The credit facility contains standard negative covenants and restrictions on actions including, without limitation, restrictions on indebtedness, liens, fundamental changes or dispositions of our assets, payments of dividends or common stock repurchases, capital expenditures, foreign investments, acquisitions, sale and leaseback transactions and swap agreements, among other restrictions. In addition, the credit agreement requires that we meet certain financial covenants, ratios and tests, including maintaining a maximum consolidated leverage ratio and a minimum interest coverage ratio, as defined in the agreement. As of December 31, 2006, we were in compliance with all covenants. Following our mandatory pay down of $16.9 million in the first quarter of 2006, our quarterly principal payments were reduced from $522,000 to $479,000. These quarterly payments will continue until March 31, 2011. The remaining principal balance of $178.8 million will be due July 7, 2011, the maturity date of the facility. Commitment fees on the unused portion of the facility, currently 37.5 basis points, may vary and are based on our consolidated leverage ratio. There is no mandatory payment in 2007 per our 2006 covenant calculations. In connection with the terms of the credit facility, on September 23, 2004, we purchased an interest rate cap and sold an interest rate floor at zero net cost, which protects us against certain interest rate fluctuations of the LIBOR rate, on $125.0 million of our variable rate debt under our credit facility. The interest rate cap and floor became effective on October 7, 2004 and expires after three years on October 9, 2007. The interest rate cap and floor consists of a LIBOR ceiling of 5.18% and a LIBOR floor that stepped up in each of the three years beginning October 7, 2004, 2005 and 2006. The LIBOR floor rates were set at 1.85%, 2.25% and 2.75% for each of the respective one-year periods. Under this interest rate hedge, we will continue to pay interest at prevailing rates plus any spread, as defined by our credit facility, but will be reimbursed for any amounts paid on LIBOR in excess of the ceiling. Conversely, we will be required to pay the financial institution that originated the instrument if LIBOR is less than the respective floor rates. We have recognized the fair value of the interest rate cap and floor as an asset of $164,000, $202,000 and $113,000 at December 31, 2006, 2005 and 2004, respectively. Under the terms of our existing credit facility, we are permitted to repurchase up to (i) $3.0 million of our common stock plus (ii) proceeds received after July 7, 2004, from the issuance of new shares of capital stock under our employee equity compensation plans. As of December 31, 2006, the authorized cumulative proceeds received from option exercises or other equity purchases under our equity compensation plans totaled $16.1 million bringing the total authorized for purchase under our credit facility to $19.1 million. After taking into consideration our share repurchases of $8.0 million in 2006, the remaining amount authorized for repurchase under our credit facility is $11.1 million. Apart from our credit facility limitations, our board of directors authorized repurchase of up to $22.5 million of our common stock plus additional shares equal to the aggregate amount of net proceeds received after January 1, 2003, from our employee equity compensation plans. This authorization would currently allow us to repurchase up to $20.6 million of our common stock, however, we will not exceed our credit facility limits. As of December 31, 2006, we had six irrevocable standby letters of credit that totaled $10.9 million. These standby letters of credit, which expire at various times through December 31, 2007 are used to collateralize certain obligations to third parties. Prior to and as of December 31, 2006, no amounts have been or are outstanding under these standby letters of credit.
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Table of ContentsWe believe our existing cash, cash equivalents and amounts available to us under our credit facility will be sufficient to fund our cash requirements and capital expenditure needs for at least the next 12 months. After that time, the extent of additional financing needed, if any, will depend on the success of our business. If we significantly increase installations beyond planned levels, or if coin-counting machine volumes generated or entertainment services machine plays are lower than historical levels, our cash needs may increase. Furthermore, our future capital requirements will depend on a number of factors, including cash required by future acquisitions, consumer usage of our services, the timing and number of machine installations, the number of available installable machines, the type and scope of service enhancements and the cost of developing potential new product and service offerings and enhancements. Off-Balance Sheet Arrangements As of December 31, 2006, off-balance sheet arrangements are comprised of obligations under our interest rate hedge disclosed in Note 6 to our Consolidated Financial Statements and our operating leases and letters of credit disclosed in Note 7 to our Consolidated Financial Statements. We have no other off-balance sheet arrangements that have had or are reasonably likely to have a material current or future effect on our financial condition or consolidated financial statements. Contractual Obligations The tables below summarize our contractual obligations and other commercial commitments as of December 31, 2006:
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Table of ContentsItem 7A. Quantitative and Qualitative Disclosures About Market Risk. We are subject to the risk of fluctuating interest rates in the normal course of business, primarily as a result of our credit agreement with JPMorgan Chase Bank and investment activities that generally bear interest at variable rates. Because our investments have maturities of three months or less, and our credit facility interest rates are based upon either the LIBOR or base rate plus an applicable margin, we believe that the risk of material loss is low and that the carrying amount of these balances approximates fair value. For our debt obligation which has a variable interest rate, the rate presented reflects our projected credit facility interest rate of LIBOR plus a margin of 2.0% and the impact of our interest rate hedge on $125.0 million of the outstanding debt balance. The table below presents principal amounts, at book value, by year of maturity and related average interest rates.
We have variable-rate debt that, at December 31, 2006, had an outstanding balance of $187.0 million. Under the terms of our credit agreement, we have entered into a zero net cost interest rate hedge on $125.0 million of this outstanding debt balance which will decrease our sensitivity to changes in the LIBOR rate. Based on our outstanding debt obligations and our interest rate hedge as of December 31, 2006, an increase of 1.0% in interest rates over the next year would increase our annualized interest expense and related cash payments by approximately $0.9 million; a decrease of 1.0% in interest rates over the next year would decrease our annualized interest expense and related cash payments by approximately $1.7 million. Such potential increases or decreases are based on certain simplified assumptions, including minimum quarterly principal repayments made on variable-rate debt for all maturities and an immediate, across-the-board increase or decrease in the level of interest rates with no other subsequent changes for the remainder of the periods. On July 7, 2004, we entered into a senior secured credit facility. As of December 31, 2006, our credit agreement provides for advances totaling up to $247.0 million, consisting of a $60.0 million revolving credit facility and a $187.0 million term loan facility. Included in the terms of this agreement was a requirement to enter into an interest rate protection agreement for a minimum notional amount of $125.0 million by October 6, 2004. Loans made pursuant to the credit agreement are secured by a first security interest in substantially all of our assets and the assets of our subsidiaries, as well as a pledge of our subsidiaries’ capital stock. The credit facility matures on July 7, 2011. On September 23, 2004, we purchased an interest rate cap and sold an interest rate floor at zero net cost, which protects us against certain interest rate fluctuations of the LIBOR rate on $125.0 million of our variable rate debt under our credit facility. The effective date of the interest rate cap and floor was October 7, 2004 and expires in three years on October 9, 2007. The interest rate cap and floor consists of a LIBOR ceiling of 5.18% and a LIBOR floor that stepped up in each of the three years beginning October 7, 2004, 2005 and 2006. The LIBOR floor rates are 1.85%, 2.25% and 2.75% for each of the respective one-year periods. Under this hedge, we will continue to pay interest at prevailing rates plus any spread, as defined by our credit facility, but will be reimbursed for any amounts paid on LIBOR in excess of the ceiling. Conversely, we will be required to pay the financial institution that originated the instrument if LIBOR is less than the respective floor rates. Item 8. Financial Statements and Supplementary Data. See Item 15 for an index to the financial statements and supplementary data required by this item, which are included as a separate section on page 37 and which are incorporated herein by reference.
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Table of ContentsSupplemental Quarterly Financial Information The following table sets forth selected unaudited quarterly financial information for the last eight quarters. This information has been prepared on the same basis as our audited consolidated financial statements and includes, in the opinion of management, all normal and recurring adjustments that management considers necessary for a fair presentation of the quarterly results for the periods. The operating results for any quarter are not necessarily indicative of the results for future periods. Certain reclassifications have been made to the prior period balances to conform with the current year presentation.
Seasonality We have historically experienced seasonality in our coin services revenue, with highest revenues experienced in the third calendar quarter, followed by the fourth calendar quarter, and relatively lower revenues in the first half of the year. Our entertainment service revenue has also experienced seasonality, with peak revenues in the fourth quarter and periods surrounding the Easter holiday season. Although our entertainment services revenue may impact the historical seasonality of the coin revenue to some degree, we expect our results
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Table of Contentsof operations will continue to fluctuate as a result of seasonal fluctuations and our revenue mix between relatively higher margin coin and e-payment services and relatively lower margin entertainment services. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. Item 9A. Controls and Procedures. (i) Disclosure Controls and Procedures. Our Chief Executive Officer and Chief Financial Officer conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined under Rule 13a-15(e) of the Securities Exchange Act of 1934). Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of December 31, 2006. (ii) Internal Control Over Financial Reporting. (a) Management’s report on internal control over financial reporting. Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in the Securities Exchange Act of 1934 Rule 13a-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2006 as required by the Securities Exchange Act of 1934 Rule 13a-15(c). In making this assessment, we used the criteria set forth in the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control-Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2006. We acquired CMT during 2006. Management excluded CMT from its assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006, including the internal control over financial reporting associated with CMT, which had total assets of $55.8 million, and total revenue of $9.0 million, which were included in our consolidated financial statements as of and for the year ended December 31, 2006. Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their attestation report which appears on page 42. (b) Attestation report of the registered public accounting firm. The attestation report of KPMG, LLP, our independent registered public accounting firm, on management’s assessment of the effectiveness of our internal control over financial reporting and the effectiveness of our internal control over financial reporting is set forth on page 42. (c) Changes in internal control over financial reporting. There was no change in our internal control over financial reporting during our fourth fiscal quarter ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. None.
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Table of ContentsItem 10. Directors and Executive Officers of the Registrant. The information required by this item is incorporated herein by reference to the Proxy Statement relating to our 2007 Annual Meeting of Stockholders. Item 11. Executive Compensation. The information required by this item is incorporated herein by reference to the Proxy Statement relating to our 2007 Annual Meeting of Stockholders. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. The information required by this item is incorporated herein by reference to the Proxy Statement relating to our 2007 Annual Meeting of Stockholders. Item 13. Certain Relationships and Related Transactions. The information required by this item is incorporated herein by reference to the Proxy Statement relating to our 2007 Annual Meeting of Stockholders. Item 14. Principal Accountant Fees and Services. The information required by this item is incorporated herein by reference to the Proxy Statement relating to our 2007 Annual Meeting of Stockholders.
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Table of ContentsItem 15. Exhibits and Financial Statement Schedules. The financial statements required by this item are submitted in a separate section beginning on page 42 of this Annual Report on Form 10-K.
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Table of ContentsSIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
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Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders Coinstar, Inc.: We have audited management’s assessment, included in the accompanying management’s report on internal control over financial reporting appearing under Item 9A that Coinstar, Inc. and subsidiaries (the “Company”), maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 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 Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company acquired Travelex Money Transfer Limited (now known as “Coinstar Money Transfer” or “CMT”), during 2006, and management excluded from its assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, the internal control over financial reporting associated with CMT, which had total assets of $55.8 million, and total revenues of $9.0 million, included in the consolidated financial statements of the Company as of and for the year ended December 31, 2006. Our audit of internal control over financial reporting of the Company also excluded an evaluation of the internal control over financial reporting of CMT. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Company as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006, and our report dated March 8, 2007 expressed an unqualified opinion on those consolidated financial statements. /s/ KPMG LLP Seattle, Washington March 8, 2007
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Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders Coinstar, Inc.: We have audited the accompanying consolidated balance sheets of Coinstar, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits 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 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 Coinstar, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. As discussed in Note 2 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, effective January 1, 2006. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Coinstar, Inc.’s internal control over financial reporting as of December 31, 2006, 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 March 8, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting. /s/ KPMG LLP Seattle, Washington March 8, 2007
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Table of ContentsCONSOLIDATED BALANCE SHEETS (in thousands, except share data)
See notes to consolidated financial statements
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Table of ContentsCONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data)
See notes to consolidated financial statements
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Table of ContentsCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (in thousands, except share data)
See notes to consolidated financial statements
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Table of ContentsCONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
See notes to consolidated financial statements
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Table of ContentsNOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2006, 2005, AND 2004 NOTE 1: ORGANIZATION AND BUSINESS Description of company: Incorporated as a Delaware company in 1993, Coinstar is a multi-national company offering a range of 4th Wall™ solutions for retailers’ storefronts consisting of self-service coin counting, electronic payment (“e-payment”) services such as money transfer services, stored value cards, payroll cards, prepaid debit cards and prepaid wireless products via point-of-sale terminals and non-coin-counting kiosks, and entertainment services such as skill-crane machines, bulk vending machines and kiddie rides. We have also made strategic investments in Redbox Automated Retail, LLC (“Redbox”) and Video Vending New York, Inc. (d.b.a. “DVDXpress”), to offer self-service DVD kiosks where consumers can rent or purchase movies. Our services, in one form or another, are currently offered in supermarkets, mass merchandisers, warehouse clubs, drugstores, universities, shopping malls and convenience stores in the United States, Canada, Mexico, Puerto Rico, the United Kingdom and other countries. As of December 31, 2006, we had a total of approximately 13,500 coin-counting machines installed, over 300,000 entertainment services machines installed, over 14,000 locations where our point-of-sale terminals were installed and over 400 non-coin-counting kiosks installed. NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of consolidation: The accompanying consolidated financial statements include the accounts of Coinstar, Inc., our wholly-owned subsidiaries and other entities in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities (“FIN 46R”). All significant intercompany balances and transactions have been eliminated in consolidation. Use of estimates: The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These judgments are difficult as matters that are inherently uncertain directly impact their valuation and accounting. Actual results may vary from management’s estimates and assumptions. Cash and cash equivalents, cash in machine or in transit, and cash being processed: We consider all highly liquid securities purchased with a maturity at purchase of three months or less to be cash equivalents. Cash in machine or in transit represents coin residing in our coin-counting or entertainment services machines, cash being processed by carriers, or cash deposits in transit. Cash being processed represents cash which we are obligated to use to settle our accrued liabilities payable to retailers. We have the contractual right and obligation to pick up and process all coins in our machines, although in certain circumstances, we may not be able to immediately access the coins until they have been deposited into one of our regional bank accounts. Coin-in-machine represents the cash deposited into our entertainment services machines at period end which has not yet been collected. Based on our estimate of coin-in-machine, we have recognized the related revenue, the corresponding reduction to inventory and increase to accrued liabilities which represents the direct operating expenses associated with the coin-in-machine estimate. The estimated value of our entertainment services coin-in-machine was approximately $7.1 million and $5.0 million at December 31, 2006 and 2005, respectively. Securities available-for-sale: Our investments are classified as available-for-sale and are stated at fair value. Our available-for-sale securities have maturities of one year or less and are reported at fair value based on
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quoted market prices and are included in the balance sheet caption “prepaid expenses and other current assets.” Changes in unrealized gains and losses are reported as a separate component of accumulated other comprehensive income. Trade accounts receivable: Trade accounts receivable represents trade receivables, net of allowances for doubtful accounts. The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience and other currently available evidence. When a specific account is deemed uncollectible, the account is written off against the allowance. In 2006, the amount expensed for uncollectible accounts was approximately $433,000 and the amount charged against the allowance was $500,000. In 2005, the amount expensed for uncollectible accounts was approximately $230,000 and the amount charged against the allowance was $220,000. Inventory: Inventory, which consists primarily of plush toys and other products dispensed from our entertainment services machines, is stated at the lower of cost or market. The cost of inventory includes mainly the cost of materials, and to a lesser extent, labor, overhead and freight. Cost is determined using the average cost method. Inventory, which is considered finished goods, consists of purchased items ready for resale or use in vending operations. Also included in inventory are prepaid airtime, prepaid phones and prepaid phone cards; cost is determined using first-in-first-out method. Property and equipment: Property and equipment are stated at cost, net of accumulated depreciation. Expenditures that extend the life, increase the capacity, or improve the efficiency of property and equipment are capitalized, while expenditures for repairs and maintenance are expensed as incurred. Depreciation is recognized using the straight-line method over the following approximate useful lives.
Equity investments: We are accounting for our minority ownership of our investments under the equity method in our consolidated financial statements, of which we received dividends from one of our investments during 2006 and 2005. During 2005, we invested $20.0 million to obtain a 47.3% interest in Redbox, a company in which consumers can rent DVD movies through self-service kiosks for about $1 per day. Our 47.3% investment included a conditional consideration agreement requiring us to contribute an additional $12.0 million if Redbox achieved certain targets within a one-year period from the date of the original agreement. In December 2006, those targets were met and the conditional consideration of $12.0 million was invested. The additional $12.0 million investment did not change our percentage ownership in Redbox. Under certain conditions, based on the terms of the agreement, we may be able to obtain a majority interest in Redbox. Purchase price allocations: In connection with our acquisitions of our entertainment and e-payment subsidiaries, we have allocated the respective purchase prices plus transaction costs to the estimated fair values of assets acquired and liabilities assumed. These purchase price allocations were based on our estimates of fair
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Table of ContentsCOINSTAR, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) YEARS ENDED DECEMBER 31, 2006, 2005, AND 2004
values and estimates from third-party consultants. Adjustments to our purchase price allocation estimates are made based on our final analysis of the fair value during the allocation period, which is within one year of the purchase date. Goodwill and intangible assets: Goodwill represents the excess of cost over the estimated fair value of net assets acquired, which is not being amortized. We test goodwill for impairment at the reporting unit level on an annual or more frequent basis as determined necessary. FASB Statement No. 142, Goodwill and Other Intangible Assets (“SFAS 142”) requires a two-step goodwill impairment test whereby the first step, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired and the second test is not performed. The second step of the impairment test is performed when required and compares the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. Based on the annual goodwill test for impairment we performed during the quarter ended December 31, 2006, we determined there is no impairment of our goodwill. Our intangible assets are comprised primarily of retailer relationships acquired in connection with our acquisition of ACMI Holdings, Inc. and its subsidiaries (collectively, “ACMI”) in 2004, The Amusement Factory L.L.C. (“Amusement Factory”) in 2005, Travelex Money Transfer Limited (now known as “Coinstar Money Transfer” or “CMT”) in 2006 and other smaller acquisitions. We used a third-party consultant, which used expectations of future cash flows to estimate the fair value of the acquired retailer relationships. We amortize our intangible assets on a straight-line basis over their expected useful lives. The gross carrying amounts and related accumulated amortization as well as the range of estimated useful lives of identifiable intangible assets at the reported balance sheet dates were as follows:
Based on identifiable intangible assets recorded as of December 31, 2006, and assuming no subsequent impairment of the underlying assets, the annual estimated aggregate future amortization expenses are as follows:
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Impairment of long-lived assets: Long-lived assets, such as property and equipment and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset group to the estimated undiscounted future cash flows expected to be generated by the asset group. If the carrying amount of an asset group exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset group exceeds the fair value of the asset group. Revenue recognition: We recognize revenue as follows:
Fees paid to retailers: Fees paid to retailers relate to the amount we pay our retailers for the benefit of placing our machines in their stores and their agreement to provide certain services on our behalf to our customers. The fee is calculated as a percentage of each coin-counting transaction or as a percentage of our entertainment revenue and is recorded in our consolidated income statement under the caption “direct operating expenses.” The fee arrangements are based on our evaluation of certain factors with the retailers such as total revenue, e-payment capabilities, long-term non-cancelable contracts, installation of our machines in high traffic and/or urban or rural locations, new product commitments, co-op marketing incentive, or other criteria. We recognize this expense at the time we recognize the associated revenue from each of our customer transactions. This expense is recorded on a straight-line basis as a percentage of revenue based on estimated annual volumes. In certain instances, we prepay amounts to our retailers, which are expensed over the contract term. The expense is included in depreciation and other in the accompanying consolidated statements of operations and cash flows. Fair value of financial instruments: The carrying amounts for cash and cash equivalents, our trade receivables and our trade payables approximate fair value, which is the amount for which the instrument could be exchanged in a current transaction between willing parties. The fair value of our term and revolving loans approximates their carrying amounts. Our interest rate derivative is carried at fair value, which is more fully described in Note 6. Foreign currency translation: The functional currencies of our International subsidiaries are the British Pound Sterling for Coinstar Limited in the United Kingdom and the Euro for CMT. We translate assets and liabilities related to these operations to U.S. dollars at the exchange rate in effect at the date of the consolidated balance sheet; we convert revenues and expenses into U.S. dollars using the average monthly exchange rates. Translation gains and losses are reported as a separate component of accumulated other comprehensive income. Stock-based compensation: Effective January 1, 2006, we adopted the fair value recognition provisions of FASB Statement No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”) using the modified–prospective transition method. Under this transition method, compensation expense recognized includes the estimated fair
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value of stock options granted on and subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R, and the estimated fair value of the portion vesting in the period for options granted prior to, but not vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). Further, in accordance with the modified-prospective transition method, results for prior periods have not been restated. Prior to the adoption of SFAS 123R on January 1, 2006, we accounted for stock-based awards to employees using the intrinsic value method in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees. All options granted under the stock-based compensation plans had an exercise price equal to the fair market value of the stock at the date of grant. Accordingly, no compensation expense, other than for restricted stock, was recognized for our stock-based compensation associated with stock options. The following table illustrates the effect on net income and net income per share had we applied the fair value recognition provision of SFAS 123 to the stock option awards. Disclosures for the year ended December 31, 2006, are not presented because the amounts are recognized in the consolidated financial statements.
The fair value for stock awards was estimated at the date of grant using the Black-Scholes-Merton (“BSM”) option valuation model. Options granted are valued using the single option valuation approach and compensation expense is recognized using a straight-line method. Total stock-based compensation expense recognized in the consolidated statement of operations for the year ended December 31, 2006, was $6.3 million, before income taxes. The related deferred tax benefit for non-qualified stock option expense was approximately $1.4 million for the year ended December 31, 2006. No amount of stock-based compensation expense was capitalized as part of the carrying cost of our assets.
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SFAS 123R requires that stock-based compensation expense be recognized only for those options and awards expected to vest. Therefore, stock-based compensation expense for the year ended December 31, 2006, has been reduced for estimated forfeitures. Forfeitures are estimated based on our historical experience and expectations of future behavior. Prior to adoption of SFAS 123R, the effect of forfeitures on the pro forma expense amounts was recognized as the forfeitures occurred. The fair value for stock awards was estimated using the BSM option valuation model with the following weighted average assumptions.
The expected term of the options represents the estimated period of time from grant until exercise and is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior. In addition, in 2005, on a prospective basis, the contractual term of the stock option awards was revised from ten to 5 years. Expected stock price volatility is based on historical volatility of our stock for a period at least equal to the expected term. The risk-free interest rate is based on the implied yield available on United States Treasury zero-coupon issues with an equivalent remaining term. We have not paid dividends in the past and do not plan to pay any dividends in the foreseeable future. The following table presents the impact of our adoption of SFAS 123R on selected line items from our consolidated financial statements for the year ended December 31, 2006.
In the fourth quarter of 2006, we elected to adopt the “long-haul” method to calculate the historical pool of windfall tax benefits, which calculates on a grant by grant basis the windfall or excess tax benefit that arose upon exercise of each award based on a comparison to the total tax deduction to the “as-if” deferred tax asset that would have been recorded had we followed the recognition provisions of SFAS 123 since its effective date. Additionally, in the fourth quarter of 2006, we elected to adopt the “tax-law ordering” method of measuring the timing in which tax deductions on stock option exercises should be recognized in the consolidated financial statements.
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Prior to the adoption of SFAS 123R we presented all tax benefits resulting from the exercise of stock options as operating cash inflows in the consolidated statements of cash flows, in accordance with the provisions of the Emerging Issues Task Force (“EITF”) Issue No. 00-15, Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option. SFAS 123R requires the benefits of tax deductions in excess of the compensation cost recognized for those options to be classified as financing cash inflows when they are realized rather than operating cash inflows, on a prospective basis. Excess tax benefits generated during the year ended December 31, 2006, was approximately $1.0 million. Income taxes: Deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of our assets and liabilities and operating loss and tax credit carryforwards. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. Deferred tax assets and liabilities and operating loss and tax credit carryforwards are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and operating loss and tax credit carryforwards are expected to be recovered or settled. Research and development: Costs incurred for research and development activities are expensed as incurred. Software costs developed for internal use are accounted for under Statement of Position (“SOP”) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Recent accounting pronouncements: In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (“FIN 48”). This interpretation clarifies the accounting for uncertainty in income taxes by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the effects of FIN 48; however, we do not expect a significant or material impact from adoption. In September 2006, the SEC staff issued Staff Accounting Bulletin (“SAB”) 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatement in Current Year Financial Statements (“SAB 108”). SAB 108 requires that public companies utilize a “dual-approach” to assessing the quantitative effects of financial misstatements. This dual approach includes both an income statement focused assessment and a balance sheet focused assessment. The guidance in SAB 108 must be applied to annual financial statements for fiscal years ending after November 15, 2006. The impact of the adoption of SAB 108 was not material to the consolidated financial statements as of and for the year ended December 31, 2006. In September 2006, the FASB issued FASB Statement No. 157, Fair Value Measures (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value and enhances disclosures about fair value measures required under other accounting pronouncements, but does not change existing guidance as to whether or not an instrument is carried at fair value. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently reviewing the provisions of SFAS 157 to determine the impact to our consolidated financial statements. Reclassifications: Certain reclassifications have been made to the prior year balances to conform to the current year presentation.
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NOTE 3: ACQUISITIONS In connection with our acquisitions, we have allocated the respective purchase prices plus transaction costs to the estimated fair values of the tangible and intangible assets acquired and liabilities assumed. These purchase price allocation estimates were based on our estimates of fair values, including consideration of estimates from third-party consultants. On May 31, 2006, we acquired CMT for $27.5 million in cash. The acquisition was effected pursuant to the Agreement for the Sale and Purchase of the Entire Issued Share Capital of Travelex Money Transfer Limited dated April 30, 2006, between Travelex Limited, Travelex Group Limited, and Coinstar. In addition to the purchase price, we incurred an estimated $2.1 million in transaction costs, including costs relating to legal, accounting and other directly related charges. The results of operations of CMT are included in our consolidated statement of operations from May 31, 2006, the date of acquisition, through December 31, 2006. CMT is one of the leading money transfer networks in terms of agent locations and countries in which we do business. In addition to company-owned locations, CMT has agreements with banks, post offices, and other retail locations to supply its service. CMT was established in mid-2003 and uses leading edge Internet-based technology to provide consumers with an easy-to-use, reliable and cost-effective way to send money around the world. We acquired CMT in order to enhance our e-payment offerings, to diversify of our available services and expand our geographic reach internationally. The assets and operations of CMT are included in our e-payment services revenues and are shown in our consolidated statements of operations. The acquisition was recorded under the purchase method of accounting and the purchase price was allocated based on the fair value of the assets acquired and liabilities assumed. The total purchase consideration consists of the following:
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The total purchase consideration has been allocated to the assets acquired and liabilities assumed, including identifiable intangible assets, based on their respective fair values at the acquisition date. The accounting for the purchase price allocation is preliminary and is subject to possible adjustments in the future, based on our final analysis of certain liabilities. The following unaudited condensed balance sheet data presents the preliminary determination of the fair value of the assets acquired and liabilities assumed as of the acquisition date.
Goodwill of $22.7 million, representing the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired in the merger, will not be amortized, consistent with the guidance in SFAS 142. No amount of this goodwill is expected to be deductible for tax purposes. We engaged a third-party consultant which used expectations of future cash flows to estimate the fair value of the acquired intangible assets and a portion of the purchase price was allocated to the following identifiable intangible assets:
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Amortization expense relating to this acquisition for the year ended December 31, 2006, was approximately $922,000. Based on identified intangible assets recorded as of December 31, 2006, and assuming no subsequent impairment of the underlying assets, the annual estimated aggregate amortization expense will be as follows:
The following unaudited pro forma information represents the results of operations for Coinstar, Inc. inclusive of CMT for the years ended December 31, 2006 and 2005, as if the acquisition had been consummated as of January 1, 2006 and January 1, 2005, respectively. This pro forma information does not purport to be indicative of what may occur in the future:
Amusement Factory: During the fourth quarter of 2005, we acquired substantially all of the assets and assumed certain operating liabilities, excluding existing debt, of Amusement Factory for $36.5 million in shares of our common stock, including cash acquired of $0.7 million. Amusement Factory was the second largest operator of entertainment services in the United States with a complete line of amusement vending services for retailers including skill-crane machines, bulk vending, kiddie rides and video games. In addition to the purchase price, we incurred approximately $0.5 million in transaction costs including amounts relating to legal and accounting charges. The results of operations of Amusement Factory from November 1, 2005 to December 31, 2005, are included in our statements of operations. Of the total purchase price, $27.1 million was allocated to goodwill, which will not be amortized, and $5.0 million represented the value of the intangible assets which will be amortized over 10 years. DVDXpress: On August 5, 2005, we entered into a credit agreement to provide DVDXpress with a $4.5 million credit facility. On July 28, 2006, the credit agreement was amended to incrementally increase the credit commitment amount up to $7.3 million at set measurement dates extending through July 1, 2007. Loans made pursuant to the credit facility are secured by a first security interest in substantially all of DVDXpress’ assets as well as a pledge of their capital stock. Interest on the unpaid balance of the loan will be at an annual rate equal to LIBOR plus three percent. As of December 31, 2006, DVDXpress has drawn down $5.5 million on this credit
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facility. Additionally, on December 7, 2005 we signed an asset purchase option agreement that allows Coinstar to purchase substantially all of DVDXpress’ business assets and liabilities in exchange for any outstanding debt and accrued interest on the credit facility plus $10,000 and contingent consideration of up to $3.5 million based on achievement of specific conditions. Effective December 7, 2005, we have consolidated the fair value of DVDXpress’ financial results into our consolidated financial statements in accordance with FIN 46R. ACMI Holdings, Inc.: On July 7, 2004, we acquired ACMI for $235.0 million. As part of this acquisition, we acquired cash totaling $11.5 million. The acquisition was effected pursuant to the “Agreement and Plan of Merger” dated May 23, 2004 between ACMI and Coinstar. ACMI offered various entertainment services, including skill-crane machines, bulk vending, kiddie rides and video games to consumers in mass merchandisers, supermarkets, warehouse clubs, restaurants, entertainment centers, truck stops and other distribution channels. In addition to the purchase price, we incurred $4.3 million in transaction costs, including investment banking fees and amounts relating to legal and accounting charges. The results of operations of ACMI since July 7, 2004, are included in our statement of operations. Goodwill of approximately $136.1 million resulted from the acquisition and is not being amortized, consistent with the guidance in SFAS 142. Of this amount, approximately $39.0 million is deductible for tax purposes. Based on identified assets of $34.4 million and assuming no subsequent impairment of the underlying assets, the annual estimated aggregate amortization expense will approximate $3.4 million each year through July 2014. NOTE 4: PROPERTY AND EQUIPMENT Property and equipment, net, consisted of the following at December 31:
During 2006 and 2005, there were no significant changes in our business, nor any changes in events or circumstances that would suggest the carrying value of fixed assets were impaired. In 2004, we recorded a charge of approximately $1.9 million for the write down of certain equipment of our prepaid services. This charge is reported in the line item titled “depreciation and other” in our consolidated statements of operations.
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NOTE 5: ACCRUED LIABILITIES Accrued liabilities consisted of the following at December 31:
During the fourth quarter of 2006, we recorded $1.6 million of expense for the proposed settlement of a recently filed lawsuit alleging wage and hour violations under the California labor code. The lawsuit was originated primarily from the employment practices of the acquired entertainment subsidiary prior to the acquisition, of which we made no admission of liability. NOTE 6: LONG-TERM DEBT Long-term debt consisted of the following at December 31:
Credit facility: On July 7, 2004, we entered into a senior secured credit facility. The credit agreement provided for advances totaling up to $310.0 million, consisting of a $60.0 million revolving credit facility and a $250.0 million term loan facility. Fees for this facility of approximately $5.7 million are being amortized over the life of the revolving line of credit and the term loan which are 5 years and 7 years, respectively. We amortize deferred finance fees on a straight-line basis which approximates the effective interest method. Loans made pursuant to the credit agreement are secured by a first security interest in substantially all of our assets and the assets of our subsidiaries, as well as a pledge of our subsidiaries’ capital stock. The credit facility matures on July 7, 2011. As of December 31, 2006, no amounts were outstanding under the revolving credit facility and our original term loan balance of $250.0 million had been reduced to $187.0 million. Advances under this credit facility may be made as either base rate loans (the higher of the Prime Rate or Federal Funds Effective Rate) or LIBOR rate loans at our election. Applicable interest rates are based upon either the LIBOR or base rate plus an applicable margin dependent upon a consolidated leverage ratio of outstanding indebtedness to EBITDA (to be calculated in accordance with the terms specified in the credit agreement). Our consolidated leverage ratios are based upon either LIBOR plus 200 basis points or the base rate plus 100 basis points. At December 31, 2006, our interest rate on this facility was 7.4%.
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The credit facility contains standard negative covenants and restrictions on actions including, without limitation, restrictions on indebtedness, liens, fundamental changes or dispositions of our assets, payments of dividends or common stock repurchases, capital expenditures, foreign investments, acquisitions, sale and leaseback transactions and swap agreements, among other restrictions. In addition, the credit agreement requires that we meet certain financial covenants, ratios and tests, including maintaining a maximum consolidated leverage ratio and a minimum interest coverage ratio, as defined in the agreement. As of December 31, 2006, we were in compliance with all covenants. Following our mandatory debt paydown of $16.9 million this year, our quarterly principal payments were reduced from $522,000 to $479,000. These quarterly principal payments will continue until March 31, 2011. The remaining principal balance of $178.8 million will be due July 7, 2011, the maturity date of the facility. Due to the mandatory debt paydown, we accelerated the expense recognition of $0.2 million in deferred finance fees related to this early retirement. Commitment fees on the unused portion of the facility, currently 37.5 basis points, may vary and are based on our consolidated leverage ratio. As of December 31, 2006, scheduled principal payments on our long-term debt are as follows:
Interest rate hedge: On September 23, 2004, we purchased an interest rate cap and sold an interest rate floor at zero net cost, which protects us against certain interest rate fluctuations of the LIBOR rate, on $125.0 million of our variable rate debt under our credit facility. The interest rate cap and floor became effective on October 7, 2004 and expires after three years on October 9, 2007. The interest rate cap and floor consists of a LIBOR ceiling of 5.18% and a LIBOR floor that stepped up in each of the three years beginning October 7, 2004, 2005 and 2006. The LIBOR floor rates are 1.85%, 2.25% and 2.75% for each of the respective one-year periods. Under this interest rate hedge, we will continue to pay interest at prevailing rates plus any spread, as defined by our credit facility, but will be reimbursed for any amounts paid on LIBOR in excess of the ceiling. Conversely, we will be required to pay the financial institution that originated the instrument if LIBOR is less than the respective floor rates. We have recognized the fair value of the interest rate cap and floor as an asset of $164,000 and $202,000 at December 31, 2006 and 2005, respectively. Any change in the fair value of the interest rate cap and floor is reported in accumulated other comprehensive income. Because the critical terms of the interest rate cap and floor and the underlying obligation are the same, there was no ineffectiveness recorded in the consolidated statements. NOTE 7: COMMITMENTS Lease commitments: Our corporate administrative, marketing and product development facility is located in a 46,070 square foot facility in Bellevue, Washington, under a lease that expires December 1, 2009. In connection with our acquisitions of Amusement Factory and ACMI, we assumed the leases for their respective corporate headquarters. See discussion in Note 16, Related Party Transactions.
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In addition, we have entered into capital lease agreements to finance the acquisition of certain automobiles. These capital leases have terms of 36 to 60 months at imputed interest rates that range from 3.0% to 16.0%. Assets under capital lease obligations aggregated $11.6 million and $6.2 million, net of $6.7 million and $2.5 million of accumulated amortization, at December 31, 2006 and 2005, respectively. A summary of our minimum lease obligations at December 31, 2006 is as follows:
Rental expense on our operating leases was $9.2 million, $11.0 million and $4.9 million for the years ended December 31, 2006, 2005 and 2004, respectively. Purchase commitments: We have entered into certain purchase agreements with suppliers of our machines, which result in total purchase commitments of $16.1 million as of December 31, 2006. Letters of credit: As of December 31, 2006, we had six irrevocable letters of credit that totaled $10.9 million. These standby letters of credit, which expire at various times through December 31, 2007, are used to collateralize certain obligations to third parties. We expect to renew these letters of credit. As of December 31, 2006, no amounts were outstanding under these standby letter of credit agreements. NOTE 8: STOCKHOLDERS’ EQUITY Treasury stock: Under the terms of our existing credit facility, we are permitted to repurchase up to $3.0 million of our common stock plus proceeds received after July 7, 2004, from the issuance of new shares of capital stock under our employee equity compensation plans. As of December 31, 2006, the authorized cumulative proceeds received from option exercises or other equity purchases under our equity compensation plans totaled $16.1 million bringing the total authorized for purchase under our credit facility to $19.1 million. After taking into consideration our share repurchases of $8.0 million during 2006, the remaining amount authorized for repurchase under our credit facility is $11.1 million.
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Apart from the credit facility limitations, on October 27, 2004, our board of directors authorized repurchase of up to $22.5 million of our common stock plus additional shares equal to the aggregate amount of net proceeds received after January 1, 2003, from our employee equity compensation plans. This authorization would currently allow us to repurchase up to $20.6 million of our common stock, however, we will not exceed our credit facility limits. NOTE 9: STOCK-BASED COMPENSATION PLANS Stock options and awards: Stock options and awards are granted to employees under the 2000 Amended and Restated Equity Incentive Plan (the “2000 Plan”) and the 1997 Amended and Restated Equity Incentive Plan (the “1997 Plan”), which generally vest over 4 years and expire after 5 years. In 2005, we revised, on a prospective basis, the contractual term of the stock option awards from ten years to five years. We have reserved a total of 770,000 shares of common stock for issuance under the 2000 Plan and 7,517,274 shares of common stock for issuance under the 1997 Plan. Stock options have been granted to officers and employees to purchase common stock at prices ranging from $0.70 to $32.64 per share, which represented fair market value at the date of grants and our best estimate of fair market value for grants issued prior to our initial public offering. Starting with the adoption of SFAS 123(R) on January 1, 2006, we began recognizing compensation expense related to the options issued under either the 2000 Plan or the 1997 Plan. Under the terms of our Amended and Restated 1997 Non-Employee Directors’ Stock Option Plan, the board of directors has provided for the automatic grant of options to purchase shares of common stock to non-employee directors. We have reserved a total of 400,000 shares of common stock for issuance under the Non-Employee Directors’ Stock Option Plan. Stock options have been granted to non-employee directors to purchase our common stock at prices of $7.38 to $32.64 per share, which represented the fair market value at the date of grant. The price ranges of all options exercised were $0.70 to $31.49 in 2006, $0.70 to $23.30 in 2005 and $0.70 to $25.84 in 2004. At December 31, 2006, there were 4,796,636 shares of unissued common stock reserved for issuance under all the Stock Plans of which 2,462,201 shares were available for future grants. The numbers of common stock options under the plans are as follows as of December 31:
As of December 31, 2006, total unrecognized stock-based compensation expense related to unvested stock options was approximately $7.5 million. This expense is expected to be recognized over a weighted average period of approximately 19 months. As of December 31, 2006, the weighted average remaining contractual term for options outstanding and options exercisable was 5.45 years and 5.57 years, respectively. As of December 31,
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2006, the aggregate intrinsic value for options outstanding and options exercisable was $22.7 million and $16.2 million, respectively. During the year ended December 31, 2006, the total intrinsic value of stock options exercised was approximately $3.4 million. The following table summarizes information about common stock options outstanding at December 31, 2006:
Restricted stock awards: Restricted stock awards are granted to certain officers and non-employee directors under the 1997 Plan, which vest annually over four years and one year, respectively. During 2006 and 2005, we granted 7,500 and 85,050, respectively, restricted stock awards with a weighted average fair value of $22.77 and $24.49, respectively, per share, the respective market price of the stock at grant date. The restricted share units require no payment from the grantee and compensation cost is recorded based on the market price on the grant date and is recorded equally over the vesting period. Compensation expense related to restricted stock awards totaled approximately $587,000 and $296,000 for the years ended December 31, 2006 and 2005, respectively. The related deferred tax benefit for restricted stock awards expense was approximately $227,000 and $117,000 for the years ended December 31, 2006 and 2005, respectively. As of December 31, 2006, total unrecognized stock-based compensation expense related to unvested restricted stock awards was approximately $1.2 million. This expense is expected to be recognized over a weighted average period of approximately 30 months. During the year ended December 31, 2006, the total fair value of restricted stock awards vested was approximately $506,000. The following table presents a summary of restricted stock award activity for the years ended December 31:
Stock purchase plan: In March 1997, we adopted the Employee Stock Purchase Plan (the “ESPP”) under Section 423(b) of the Internal Revenue Code. Under the ESPP, the board of directors may authorize participation by eligible employees, including officers, in periodic offerings. The total number of shares reserved for issuance
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under this plan was 600,000. Eligible employees participated through payroll deductions in amounts related to their basic compensation. At the end of each six-month offering period, shares were purchased by the participants at 85% of the lower of the fair market value at the beginning of the offering period or the end of a purchase period. During 2005 and 2004 stock purchases totaling $989,000 and $770,000, respectively, were made as a result of payroll deductions from employees. Actual shares purchased by participating employees in 2005 and 2004 totaled 82,454 and 66,126 at an average price of $11.99 and $11.65, respectively. As of December 31, 2006, we no longer have an Employee Stock Purchase Plan, as the plan period ended July 31, 2005 and was not renewed. NOTE 10: INCOME TAXES The components of income (loss) before income taxes were as follows:
The components of income tax expense (benefit) were as follows:
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The income tax expense differs from the amount that would result by applying the U.S. statutory rate to income before income taxes. A reconciliation of the difference follows:
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