|
|
 | | | |
- close
- close
- close
- close
| |||||||||
Danka Business Systems 10-K 2006 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 March 31, 2006.
for the transition period from to . Commission file number: 0-20828
DANKA BUSINESS SYSTEMS PLC (Exact name of registrant as specified in its charter)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: (727) 622-2100 in the United States 011-44-207-605-0150 in the United Kingdom
Securities registered pursuant to Section 12(g) of the Act: Ordinary Shares 1.25 p each
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.
Indicate by a check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act. ¨ Yes x No The aggregate market value of voting shares held by non-affiliates of the registrant as of September 30, 2005 was $171,155,619 based on the average bid and asked prices of American Depositary Shares or ADSs, as quoted on the NASDAQ SmallCap Market. As of June 1, 2006, the registrant had 256,529,024 ordinary shares outstanding, including 56,683,487 represented by ADSs. Each ADS represents four ordinary shares. The ADSs are evidenced by American depositary receipts.
Table of ContentsDANKA BUSINESS SYSTEMS PLC Annual Report on Form 10-K for March 31, 2006 TABLE OF CONTENTS
2
Table of ContentsSPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS Certain statements contained herein, or otherwise made by our officers, including statements related to our future performance and our outlook for our businesses and respective markets, projections, statements of our plans or objectives, forecasts of market trends and other matters, are forward-looking statements, and contain information relating to us that is based on our beliefs as well as assumptions, made by, and information currently available to us. The words “goal”, “anticipate”, “expect”, “believe”, “could”, “should”, “intend” and similar expressions as they relate to us are intended to identify forward-looking statements, although not all forward looking statements contain such identifying words. No assurance can be given that the results in any forward-looking statement will be achieved. For the forward-looking statements, we claim the protection of the safe harbor for forward-looking statements provided for in the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, or the Exchange Act. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties and assumptions that could cause actual results to differ materially from those reflected in the forward-looking statements. Factors that might cause such actual results to differ materially from those reflected in any forward-looking statements include, but are not limited to, the following: (i) any inability to successfully implement our strategy; (ii) any inability to successfully implement our cost restructuring plans to achieve and maintain cost savings; (iii) any inability to comply with the Sarbanes-Oxley Act of 2002; (iv) any material adverse change in financial markets, the economy or in our financial position; (v) increased competition in our industry and the discounting of products by our competitors; (vi) new competition from non-traditional competitors as the result of evolving and converging technology; (vii) any inability by us to procure, or any inability by us to continue to gain access to and successfully distribute current and new products, including digital products, color products, multi-function products and high-volume copiers, or to continue to bring current products to the marketplace at competitive costs and prices; (viii) any inability to arrange financing for our customers’ purchases of equipment from us; (ix) any inability to successfully enhance, unify and effectively utilize our management information systems; (x) any inability to access vendor or bank lines of credit, which could adversely affect our liquidity; (xi) any inability to record and process key data due to ineffective implementation of business processes and policies; (xii) any negative impact from the loss of a key vendor or customer; (xiii) any negative impact from the loss of any of our senior or key management personnel; (xiv) any change in economic conditions in markets where we operate or have material investments which may affect demand for our products or services; (xv) any negative impact from the international scope of our operations; (xvi) fluctuations in foreign currencies; (xvii) any incurrence of tax liabilities or tax payments beyond our current expectations, which could adversely affect our liquidity and profitability; (xviii) any inability to continue to access our credit facilities, or comply with the financial or other representations, warranties or covenants in our debt instruments; (xix) any delayed or lost sales or other impacts related to the commercial and economic disruption caused by natural disasters, including hurricanes; (xx) any delayed or lost sales and other impacts related to the commercial and economic disruption caused by terrorist attacks, the related war on terrorism, and the fear of additional terrorist attacks; (xxi) any inability by us to remediate our material weaknesses and (xxii) other risks including those risks identified in any of our filings with the Securities and Exchange Commission. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect our analysis only as of the date they are made. Except as required by applicable law, we undertake no obligation, and do not intend, to update these forward-looking statements to reflect events or circumstances that arise after the date they are made. Furthermore, as a matter of policy, we do not generally make any specific projections as to future earnings, nor do we endorse any projections regarding future performance, which may be made by others outside our company.
3
Table of ContentsRISK FACTORS Business Strategy—Danka Business Systems PLC (also referred to herein as “Danka”, the “Company”, “we”, “us” or “our”) believes that in order to stay competitive and generate positive earnings and cash flow, we must successfully implement our strategies. In connection with the implementation of our strategies, we have launched, and expect to continue to launch, several operational and strategic initiatives. However, the success of any of these initiatives may not be achieved if:
Failure to implement one or more of our strategies and related initiatives could materially and adversely affect our business, financial condition or results of operations. Operating Earnings—We generated an operating loss for fiscal year 2006 of $24.7 million due to decreased revenue and gross margins and increased restructuring charges. The operating losses for fiscal year 2006 included $12.5 million in restructuring charges. If we are not able to increase our revenue and improve our gross margins or reduce our operating costs, these operating losses may continue in the future. As we continue to evaluate our business and strategies, we could incur future operating losses and/or restructuring charges which may materially and adversely affect our operations, financial position, liquidity and results of operations. If we incur operating losses or do not generate sufficient profitability in the future, our growth potential and our ability to execute our business strategy may be limited. In addition, our ability to service our indebtedness may be impaired because we may not generate sufficient cash flow from operations to pay principal or interest when due. Restructuring of Operations—We have implemented plans to reduce costs in order to become more competitive within our industry. These cost reduction plans involve, among other things, the outlay of cash for significant headcount reductions, the exit of certain non-strategic and non-core facilities, markets and products, the consolidation of many back-office functions into more centralized locations and the outsourcing of resource management functions and business process changes. If we fail to successfully implement our cost restructuring plans, including the timely buyout or sublease of vacant facilities, and fail to achieve our other long-term cost reduction goals, we may not reduce costs quickly enough to become more competitive within our industry or obtain necessary return on our cash investments. Additionally, we may lose valuable institutional knowledge, bear the risk of additional costs and expenses and incur a breakdown in our business and operational functions, including certain critical back-office operations, any of which could result in negative consequences to our customer service, our current internal control environment and operating results. Indebtedness—At March 31, 2006, we had consolidated indebtedness, including current maturities of long-term debt and notes payable, of $249.6 million which included $64.5 million in principal amount of 10.0% subordinated notes due April 1, 2008 and $175.0 million in principal amount of 11.0% senior notes due June 15, 2010, less unamortized discount of $2.8 million. The subordinated notes accrue interest which is paid every six months on April 1 and October 1 while the senior notes accrue interest which is paid every six months on June 15 and December 15. The amount of our indebtedness could have important consequences to us, including the following:
Debt and Credit Facilities—The indenture governing our senior notes and our $50 million senior secured revolving credit facility with Bank of America, which acquired Fleet Capital Corporation (or “Fleet Credit Facility”), contains representations, warranties and covenants that, among other things, limit our ability to: (1) incur additional indebtedness or, in the case of our restricted subsidiaries,
4
Table of Contentsissue preferred stock; (2) create liens; (3) pay dividends or make other restricted payments; (4) make certain investments; (5) sell or make certain dispositions of assets or engage in sale and leaseback transactions; (6) engage in transactions with affiliates; (7) engage in certain business activities; and (8) engage in mergers or consolidations. They also restrict the ability of our restricted subsidiaries to pay dividends, or make other payments to us. In addition, the indenture governing the senior notes may require us to use a portion of our excess cash flow (as defined in the indenture) to repay other senior indebtedness or offer to repurchase the senior notes. Competition—The industry in which we operate is highly competitive. We have competitors in all markets in which we operate, and our competitors include a number of companies worldwide with significant technological, distribution and financial resources. Competition in our industry is based upon many factors, including technology, performance, pricing, quality, reliability, distribution, market coverage, customer service and support and lease and rental financing. In addition, our equipment suppliers have established themselves as direct competitors in many of the areas in which we do business, and non-traditional competitors, primarily printer manufacturers, are developing technologies designed to lower prices. Besides competition from within the office imaging industry, we are also experiencing competition from other sources as a result of evolving technology, including the development of alternative means of document processing, retention, storage and printing. Our retail equipment operations are in direct competition with local and regional equipment suppliers and dealers, manufacturers, mass merchandisers and wholesale clubs. We have suffered, and may continue to suffer, a reduction of our market share because of the high level of competition in our industry. The intense competition in our industry may result in pressure on the prices and margins that we can obtain for our products and may affect our ability to retain customers, both of which could materially and adversely affect our business, financial condition or results of operations. As our suppliers develop new products, there is no guarantee that they will permit us to distribute such products or that such products will meet our customers’ needs and demands. In addition, some of our principal competitors design and manufacture new technology, which may give them a competitive advantage over us. Furthermore, there is a trend within our industry to offer on-demand pricing where the customer does not buy or lease the equipment. Rather, the customer is only charged for the number of images produced by the equipment. This trend could require us to increase our rental equipment investments in order to remain competitive and we may not have the capital available to do so. Additionally, the competitive environment hinders employee retention, especially in the sales and service areas, which leads to higher turnover of employees, increased compensation expense and lower employee productivity. Vendor Relationships—We primarily have relationships with Canon, Ricoh, Toshiba, Kodak, Hewlett-Packard and Konica-Minolta. These companies manufacture equipment, parts, supplies and software for resale by us in the markets in which we operate. We also rely on our equipment suppliers for related parts and supplies, vendor rebates and significant levels of vendor trade creditor financing for our purchases of products from them. Any inability to obtain equipment, parts, supplies or software in the volumes required and at competitive prices from our major vendors, or the loss of any major vendor, or the discontinuation of vendor rebate programs or adequate levels of vendor financing may seriously harm our business because we may not be able to supply those vendors’ products to our customers on a timely basis in sufficient quantities or at all. In addition, we rely on our vendors to effectively respond to changing technology and manufacture new products to meet the demands of evolving customer needs. There is no guarantee that these vendors or any of our other vendors will effectively respond to changing technology, continue to sell their products and services to us, or that they will do so at competitive prices. Other factors, including reduced access to credit by our vendors resulting from economic conditions, may impair our vendors’ ability to effectively respond to changing technology or provide products in a timely manner or at competitive prices. We also rely on non-equipment vendors for critical services such as transportation, supply chain and professional services. Any negative impacts to our business or liquidity could adversely impact our ability to establish or maintain these relationships. Technological Changes—The industry in which we operate is characterized by rapidly changing technology. Technological changes have contributed to declines in our revenues in the past and may continue to do so in the future. For example, the office imaging industry has changed from analog to digital copiers, multi-function peripherals (“MFPs”) and printers. Most of our digital products replaced analog products, which have historically been a significant percentage of our machines in field (“MIF”). Digital copiers and MFPs are more reliable than analog copiers and require less maintenance. Moreover, color printing and copying represents an important and growing part of our industry. We must improve our execution of color equipment sales and meet the demand for color products if we are to maintain and improve our operating performance and our ability to compete. To meet these trends, manufacturers are accelerating the introduction of products and new technology to address the growing need for color. These include both cartridge based laser imaging systems, and newer inkjet based systems. Partially as a result of these technology trends, the industry and we are seeing increased downward pressure on average selling prices for both equipment and the accompanying service and supply contracts. Furthermore, the success of the cartridge based systems may put further pressure on the willingness of our traditional customers to enter into long-term service contracts, or service contracts at all. Another industry change that has been fueled by technological changes is the migration of copy volume from traditional stand-alone copiers to network printers. This change allows end users to print distributed documents on printers linked directly to their personal computers as opposed to receiving copies of such documents that were copied on a traditional stand-alone copier. We will need to
5
Table of Contentsincreasingly provide comprehensive solutions to our customers, such as offering digital copiers, MFPs, software solutions and printers that are directly linked to their networks, in order to remain competitive. Finally, the speed of technological changes may cause us in the future to write down our inventory, including, but not limited to, showroom, rental and other equipment and related supplies and parts, including parts and supplies for our TechSource initiative, as a result of obsolescence. In order to remain competitive, we must quickly and effectively respond to changing technology. Otherwise, such developments of technologies in our industry may impair our business, financial condition, results of operations or competitive position. Third Party Financing Arrangements—A large majority of our retail equipment and related sales are financed by third party finance or leasing companies. We have an agreement with General Electric Capital Corporation (or “GECC”), under which GECC has agreed to provide financing to our qualified United States customers to purchase equipment from us. Although we have other financing arrangements in place, GECC finances a significant part of our United States business. GECC has current and prospective lease financing agreements with our competitors. If these agreements result in more favorable terms to our competitors than our current agreement with GECC, we may be placed at a competitive disadvantage within the industry in arranging third party financing to our customers, which could negatively affect our operating results. With respect to our customers outside the United States, we have country by country arrangements with various third party finance and leasing companies. Our largest third party financing company in Europe, which is centrally organized, is De Lage Landen International B.V. (“DLL”), a 100% owned subsidiary of Rabobank. In December 2005, DLL issued notice of termination of its existing local operating agreements. These terminations are effective June 2006. We are currently in discussions with DLL to negotiate new agreements on or before the expiration of the existing agreements. While we currently have meaningful alternative lease funding sources available in most of Europe (including ING Group, BNP Paribas and GECC), failure to negotiate a new agreement with DLL could adversely impact our revenue and profitability as a change in lease companies can involve higher costs and early lease termination penalties compared to the existing DLL agreements. If we were to breach the covenants or other restrictions in our agreements with one or more of our financing sources, including GECC and our non-U.S. leasing sources or our financial condition were to deteriorate, such sources might refuse to provide financing to our customers, require additional security or protection, or exercise other remedies of default. If one or more of our financing sources were to fail to provide financing to our customers, and we were unable to arrange alternative financing on similar terms or provide financing ourselves, those customers might be unable to purchase equipment from us. In addition, if we were unable to arrange financing, we would lose sales, which could negatively affect our operating results. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Other Financing Arrangements—General Electric Capital Corporation”. Information Systems—Certain of our Europe/Australia operations run on numerous, disparate legacy IT systems that are outdated and incompatible. The operation and coordination of these management information systems and billings systems are labor intensive and expensive. We have determined that we need to upgrade our information systems and have standardized our network infrastructure and email system across Europe/Australia. Oracle has been implemented in Italy and the Netherlands, and other countries may be upgraded from the existing legacy systems to the latest Oracle releases where possible. The failure to solve our management information system issues in those Europe/Australia operations or any disruption in our business processes when we upgrade any of our IT systems worldwide could materially and adversely affect our operations, internal controls, financial position or results of operations. Disaster Recovery—Our systems in the United States are designed for security and reliability. We regularly back up our information systems and subject them to a virus scan. These efforts are intended to buttress the integrity and security of our information systems and the data stored in them, and to minimize the potential for loss in the event of a disaster, including, but not limited to, natural disasters or terrorist attacks. During fiscal year 2005, we entered into a hosting agreement with IBM for the management of our U.S. information systems infrastructure. This arrangement has relocated our data center out of Florida to a secure location in Atlanta, Georgia, which we believe has provided an additional disaster recovery capability. Our facilities have reserve power generating systems to prevent the loss of power and minimize downtime in the event of shortages; however, should a natural disaster impact our critical United States facilities, which are primarily located in St. Petersburg, Florida, we may suffer disruption of certain critical support functions. Due to the delayed investment in our information systems in certain of our Europe/Australia operations, we have not adequately invested in disaster recovery systems in all of our operations. In the event that one or more of our business systems in those operations were to fail, we would be at risk of not being able to process or record transactions or losing valuable business knowledge in the locations where the failure occurred. We are developing a comprehensive disaster recovery plan but until it is implemented, a disaster could materially and adversely affect our business, financial condition, results of operations or competitive position. Business Processes and Policies—Our past rapid expansion through acquisitions, past financial difficulties and a historical lack of focus on, and investment in, our information systems have impeded our ability to develop and implement internal controls and business processes consistently and enforce policies effectively. We have identified instances where we do not have adequate processes in place or our business processes and policies have not been properly implemented or followed in the past, which have resulted in, among other things, poor billing and credit practices, weak customer contract management, excessive and undisciplined issuances of customer credits, inaccurate customer data, inconsistent customer contract terms and conditions and inadequate document
6
Table of Contentsretention. We continue to address these issues and will implement the following steps to remediate:
While these steps are currently underway, there is no assurance that all of these issues will be completely rectified. See our discussion in Item 9A-Controls and Procedures regarding a material weakness in our revenue and billing process. International Scope of Operations—We are incorporated under the laws of England and Wales, and we conduct a significant portion of our business outside of the United States. We generated 52.3% of our revenue outside the United States during fiscal year 2006. We market office imaging equipment, document solutions and related services and supplies directly to customers in over 15 countries. The international scope of our operations may lead to volatile financial results and difficulties in managing our operations because of, but not limited to, the following:
With respect to our international operations that are experiencing difficulties as described above, we continue to evaluate the viability and future prospects of these businesses. Based on these evaluations, we sold operations in Canada and Central and South America during fiscal year 2006, and sold operations in Portugal and Russia during fiscal year 2005. Should we decide to downsize or exit any of our other businesses, we could incur costs relating to severance, closure of facilities and write-off of goodwill, and we may also be required to recognize cumulative translation losses and minimum pension liabilities that would reduce our earnings. Any of these factors could materially and adversely affect our business, financial condition or results of operations. Currency Fluctuations—As a multinational company, changes in currency exchange rates affect our revenues, cost of sales and operating expenses. In addition, fluctuations in exchange rates between the United States dollar and the currencies in each of the countries in which we operate affect the results of our operations and the value of the net assets of our non-United States operations when reported in United States dollars in our United States financial statements. These fluctuations may negatively impact our results of operations or financial condition or, in some circumstances, may positively impact our results of operations disproportionately to underlying levels of actual growth or improvement in our businesses. The majority of our revenues outside the United States are denominated in either the euro or the British pound sterling. During fiscal year 2006, the euro weakened 6.4% against the United States dollar and the British pound sterling weakened 7.9% against the United States dollar, resulting in lower revenues. Further, our intercompany loans are subject to fluctuations in exchange rates between the United States dollar and the currencies in each of the countries in which we operate, primarily the euro and the British pound sterling. Based on the outstanding balance of our intercompany loans at March 31, 2006, an increase of 1% in the exchange rate for the euro and British pound sterling versus the United States dollar would cause a foreign exchange loss of less than $0.1 million, while a decrease of 1% in the exchange rate of the euro and the British pound sterling versus the U.S. dollar would cause a foreign exchange gain of less than $0.1 million. Moreover, we pay for some inventory in euro countries in United States dollars, but we generally invoice our customers in such countries in euros. Generally, if the euro weakens against the United States dollar, our operating margins and cash flow may be negatively impacted when we receive payment in euros but we pay our suppliers in United States dollars. We do not currently hedge our exposure to changes in foreign currency.
7
Table of ContentsTax Payments—We are either currently under audit or may be audited in the key tax jurisdictions in which we operate. While we believe we are adequately reserved for such liabilities, should revenue agencies impose assessments or require payments in excess of those we currently expect to pay, we could be required to record additional liabilities. Additionally, our liquidity could be adversely affected based upon the size and timing of such payments. Economic Uncertainty—The profitability of our business is susceptible to uncertainties in the global economy. Overall demand for our products and services and our profit margins may decline as a direct result of an economic recession, inflation, interest rates, governmental fiscal policy, or other macroeconomic factors which are out of our control. As a result, our customers may reduce or delay expenditures for our products and services. Disclosure Controls and Procedures and Internal Controls—We maintain disclosure controls and procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our Audit Committee and management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Our objective is to maintain internal controls that are designed to provide reasonable assurance that (1) our transactions are properly authorized; (2) our assets are safeguarded against unauthorized or improper use; and (3) our transactions are properly recorded and reported, in order to permit the preparation of our consolidated financial statements in conformity with generally accepted accounting principles and to comply with Sections 302, 906 and 404 of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act” or “Sarbanes-Oxley”). A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of errors or fraud, if any, within a company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of one or more individuals, by collusion of two or more individuals, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Further, because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Compliance with Sarbanes-Oxley Act of 2002—Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, our management is required to report on, and our independent auditors are required to attest to, the effectiveness of our internal controls over financial reporting on an ongoing basis. Our assessment, testing and evaluation of the design and operating effectiveness of our internal control over financial reporting is ongoing. As a result of our assessment conducted as of March 31, 2006, we identified a material weakness in our revenue and billing process. We are committed to addressing this material weakness. However, if we are unsuccessful in our focused effort to permanently and effectively remediate this material weakness, or otherwise fail to maintain adequate internal controls over financial reporting, our ability to accurately and timely report our financial condition may be adversely impacted. In addition, if we do not remediate this weakness, we will not be able to conclude, pursuant to Section 404 of the Sarbanes-Oxley Act and Item 308 of Regulation S-K, that our internal controls over financial reporting are effective in the current fiscal year. It is not possible to say at this time what conclusions our management or independent registered public accounting firm might reach with respect to the effectiveness of our internal controls over financial reporting at the end of fiscal year 2007. In the event of non-compliance, we may lose the trust of our customers, suppliers and security holders, and our stock price could be adversely impacted. For more information, see “Controls and Procedures” in Item 9A. Controls and Procedures, included in this report. Compliance with this legislation will continue to divert management’s attention and resources and is expected to cause us to incur significant expense in the foreseeable future. Share Price—The market price of our ordinary shares and American Depositary Shares (or “ADSs”) could be subject to significant fluctuations as a result of many factors. In addition, global stock markets have from time to time experienced significant price and volume fluctuations. These fluctuations may lead to a drop in the market price of our ordinary shares and ADSs. Factors which may add to the volatility of the price of our ordinary shares and ADSs include many of the factors set out above, and may also include changes in liquidity in the market for our ordinary shares and ADSs, sales of our ordinary shares and ADSs, investor sentiment towards the business sector in which we operate and conditions in the capital markets generally. Many of these factors are beyond our control. These factors may change the market price of our ordinary shares and ADSs, regardless of our operating performance. Dividends on Ordinary Shares—We have not paid any cash or other dividends on our ordinary shares since 1998 and we do not expect to do so for the foreseeable future. We are an English company and, under English law, we are allowed to pay dividends to shareholders only if, as determined by reference to our financial statements prepared in accordance with International Financial Reporting Standards;
8
Table of Contents
As of the date of filing of this annual report, we have insufficient accumulated, realized profits to pay dividends on our ordinary shares. In addition, our Fleet Credit Facility prohibits us from paying dividends on our ordinary shares without our lenders’ consent, and the indenture governing the senior notes restricts our ability to pay such dividends. Also, we may pay dividends on our ordinary shares only if we have paid all dividends due on our 6.50% senior convertible participating shares. ADDITIONAL INFORMATION AVAILABLE ON COMPANY WEB-SITE Our most recent Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports may be viewed or downloaded electronically, free of charge, from our website: http://www.danka.com as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Our recent press releases are also available to be viewed or downloaded electronically at http://www.danka.com. We will also provide electronic or paper copies of our SEC filings free of charge on request. Any information on or linked from our website is not incorporated by reference into this Annual Report on Form 10-K.
9
Table of ContentsITEM 1. BUSINESS Based on revenue, we are one of the largest independent providers of comprehensive document solutions including office imaging equipment, software, support, and related services and supplies in the United States and Europe/Australia. We offer a wide range of state of the art office imaging products, services, supplies and solutions that primarily include digital and color copiers, digital and color multifunction peripherals, (“MFPs”) facsimile machines and software, contract services, including professional and consulting services, maintenance, supplies, leasing arrangements, technical support and training, collectively referred to as Danka Document Services. We operate in over 15 countries and employ approximately 4,500 individuals. We generated approximately 48% of our total revenue for fiscal year 2006 from within the United States and 52% from Europe and Australia. Our revenue is generated from two primary sources: (1) new retail equipment and related sales and (2) service and supply contracts. We primarily sell Canon products in the United States and Ricoh products, on a retail and wholesale basis under our proprietary Infotec tradename, in Europe. We also sell other brands, including Kodak/Nexpress, Toshiba, Konica-Minolta and Hewlett-Packard. A significant portion of our retail equipment and related sales are made to existing customers, and nearly all are sold with a service or supply contract. In the United States, these contracts typically have an initial term of one to three years and renew on an annual basis thereafter, whereas in Europe, these contracts typically have a term of one to five years. A large majority of our retail equipment and related sales are financed by third party finance or leasing companies. For fiscal year 2006, retail equipment and related sales accounted for approximately 39% of our total revenue. Our marketing and selling efforts target the mid- to high-volume black and white image market, which is concentrated in monochrome equipment that can produce from 31 to greater than 91 copies per minute, and the growing color image market. Within these markets, our primary products include state of the art digital and color copiers and MFPs that copy, print, scan and fax information and related software and service. We have a world-wide installed machine base of analog and digital copiers and MFPs of approximately 250,000 units, which we refer to as machines in field (“MIF”), which generate monthly recurring revenues under our service contracts. Our service revenue generated from these contracts is closely correlated to the number, type and mix of analog, digital and digitally-connected machines in our MIF. In fiscal year 2006, our service revenue accounted for approximately 46% of our total revenue. We are a public limited company organized under the laws of England and Wales and we were incorporated on March 13, 1973. Our Industry The office imaging industry consists of the production and supply of various imaging products, as well as the provision of after-market products and services. The global digital printing peripherals equipment market, excluding services, is estimated to be $100 billion in 2007, segmented approximately equally between the United States, Europe and the rest of the world. The office imaging industry is comprised of large office equipment manufacturers, independent distributors and, as technologies continue to evolve, traditional desktop and network printer companies. Office imaging products are sold primarily through four channels of distribution: distributors, original equipment manufacturers, or OEMs, independent dealer sales and retail sales. Distributor and independent dealer sales result from customer calls performed by independent dealer outlets that generally sell manufacturer-branded products. Retail sales include sales of low-end products typically through national retail outlets or smaller local dealers. Direct sales by office equipment manufacturers involve the marketing of products by sales representatives working directly for the manufacturer. See our discussion in Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations regarding financial and geographical information relating to our business segments.
10
Table of ContentsThere are several trends that are prevalent in the office imaging industry, including:
Products and Services Office Imaging Systems We offer a large selection of the top brands of office imaging products as part of our document solutions packages. These products represent a full complement of digital and color copiers, digital and color MFPs and facsimile machines, as well as print management software and related parts and supplies. In the United States, we sell high-volume products, which include the Kodak/Nexpress Digimaster, Canon iR 105, as well as the Toshiba e-Studio series of digital products. In the mid-volume segment, we sell the full range of Canon iR and Toshiba e-Studio series digital copiers and MFPs. In the color segment, we sell the Canon CLC series of products as well as the Toshiba e-Studio line of color products. In addition, we sell a full complement of front end print server equipment and a portfolio of applications software which enhances the features and functions of the equipment. For example, among other things, certain of these software products:
In Europe, we sell the Kodak/Nexpress Digimaster, as well as high-volume products manufactured by Ricoh under our Infotec brand name, Canon, Toshiba and Hewlett-Packard. We also sell a full range of Ricoh/Infotec and Canon iR products in the mid-volume range in Europe, where we also sell a full portfolio of print server equipment and software with the capabilities described above. Technical Services We also offer a broad range of field technical services which primarily involve the service and maintenance of our MIF. Our worldwide network of field engineers is dedicated to ensuring that customers get maximum up time from their investment in our office imaging systems. Our field engineers are highly trained and capable of servicing multiple equipment brands and are equipped with the experience, training, tools and parts necessary to ensure that customers are provided with rapid response time and first-time fix
11
Table of Contentscapability. Field engineers have access to a computerized warehouse system that stocks thousands of parts for immediate delivery to customers, and are equipped with laptop computers which contain reference materials and diagnostic software to assist with the early resolution of customer issues. We generally offer our technical services pursuant to contracts. Our service and supply contracts typically have an initial term of one to three years in the U.S. and four to five years in Europe and renew on an annual basis thereafter. New systems, as designed by manufacturers, are increasingly incorporating new technology into their MFPs, that permit field maintenance to be performed by replacing key components with field replaceable units, or FRUs. This trend may result in customer’s requesting additional flexibility in their maintenance contracts that permit higher levels of self maintenance or time and materials engagements, and may impact the company’s service revenue model. Professional Services and Software We offer a portfolio of value-added service and software offerings that provide our customers with efficiency and cost savings opportunities, as well as provide us with supplemental revenue streams. Through our field deployed systems engineers and analysts we provide consulting services to our customers to help them reduce print costs, optimize the use of their office imaging equipment and improve their employees’ productivity by integrating our proven software solutions to leverage their investment in their imaging equipment. This expert guidance in the United States is backed by our world-class Digital Solutions Center that replicates customer environments and provides advanced diagnostic and support services. The group’s services include:
In Europe, we also provide services through country level support centers that offer many of the services listed above. Competition The industry in which we operate is highly competitive. We have competitors in all markets in which we operate, and our competitors include a number of companies worldwide with significant technological, distribution and financial resources. Competition in our industry is based largely upon technology, performance, pricing, quality, reliability, distribution, customer service and support and lease and rental financing. In addition, our equipment suppliers continue to establish themselves as direct competitors in many of the areas in which we do business. Some manufacturers of products in our industry have been consolidating in an attempt to gain market share and reduce costs. As such, the availability of certain products may become constrained or such products may become unavailable. Such consolidations may negatively impact our relationships with certain of our partners within the industry. Besides competition from within the office imaging industry, we are also experiencing competition from other sources as a result of evolving technology, including the development of alternative means of document processing, retention, storage and printing. Our retail operations are in direct competition with local and regional equipment suppliers and dealers, manufacturers, mass merchandisers and wholesale clubs. We have suffered, and may continue to suffer, a reduction of our market share because of the high level of competition in our industry. The intense competition in our industry may result in pressure on the prices and margins that we can obtain for our products and may affect our ability to retain customers.
12
Table of ContentsSeasonality We have experienced some seasonality in our business. Our European operations have historically experienced lower revenue for the second quarter of our fiscal year, which is the three month period ended September 30th. This is primarily due to increased vacation time by European residents during July and August. This has historically resulted in reduced sales activity and reduced usage of photocopiers, facsimiles and other office imaging equipment during that period. Employees As of March 31, 2006, we employed approximately 4,500 persons, with approximately 2,130 in our United States segment and approximately 2,370 in our Europe/Australia segment. Some of our European employees are subject to labor agreements that, among other things, establish rates of pay and working hours. We believe that we provide working conditions and wages that are comparable to those of our competitors. Trademarks and Service Marks We believe that our trademarks and service marks have gained recognition in the office imaging and document management industry and are important to our marketing efforts. We have registered various trademarks and service marks. In particular, we believe that the trademarks “Danka,” “Infotec,” “TechSource” and “Danka @ the Desktop” are important to our ongoing business. Our policy is to continue to pursue registration of our marks whenever possible and to vigorously oppose any infringement of our proprietary rights. Depending on the jurisdiction, trademarks and service marks are valid as long as they are in use and/or their registrations are properly maintained, and they have not been found to become generic. Registrations of trademarks and service marks in the United States can generally be renewed indefinitely as long as the trademarks and service marks are in use. Backlog Backlogs are not material to our business. ITEM 2. PROPERTIES Our general policy is to lease, rather than own, our business locations. We lease numerous properties for administration, sales, service and distribution functions and for our retail and wholesale operations. As of March 31, 2006, our principal facilities include 206,000 square feet of leased office space in St. Petersburg, Florida that we use for our U.S. and corporate operations. The terms vary under the leases. Some of our leases contain a right of first refusal or an option to purchase the underlying real property and improvements. In general, our lease agreements require us to pay our proportionate share of taxes, common area expenses, insurance and related costs of the rental properties. Our management believes that the properties we occupy are, in general, suitable and adequate for the purposes for which they are used. ITEM 3. LEGAL PROCEEDINGS In June 2003, we were served with a putative class action complaint titled Stephen L. Edwards, et al., Plaintiffs vs. Danka Industries, Inc., et al., including American Business Credit Corporation, Defendants, alleging claims of breach of contract, fraud/intentional misrepresentation, unjust enrichment, violation of the Florida Deception and Unfair Trade Protection Act and seeking injunctive relief. The claim was filed in the state court in Tennessee, and we have removed the claim to the United States District Court for the Middle District of Tennessee for further proceedings. The plaintiffs have filed a motion to certify the class, which we have opposed. We have filed a motion for summary judgment, which plaintiffs have opposed. While the amount sought in the complaint is in excess of $75,000, we cannot, at this time, estimate its potential exposure. We intend to vigorously defend all claims alleged by the plaintiffs. We are also subject to legal proceedings and claims which arise in the ordinary course of our business. We do not expect these legal proceedings to have a material effect upon our financial position, results of operations or liquidity. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of fiscal year 2006.
13
Table of ContentsITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES The following table sets forth the high and low sale price for our ADSs, as reported by the NASDAQ SmallCap Market and the high and low middle market quotations, which represent an average of bid and offered prices in pence, for the ordinary shares as reported on the Official List of the London Stock Exchange. Each ADS represents four ordinary shares.
As of June 1, 2006, 56,683,487 ADSs were held of record by 1,672 registered holders and 256,529,024 ordinary shares were held of record by 2,721 registered holders. Since some of the ADSs and ordinary shares are held by nominees, the number of holders may not be representative of the number of beneficial owners. We most recently paid a dividend to shareholders on July 28, 1998. We are an English company and we currently have insufficient profits, as determined under English law, to pay dividends on our ordinary shares. In addition, we are not currently permitted to pay dividends, other than payment-in-kind dividends on our participating shares, under our senior credit facility. We do not expect to pay dividends on our ordinary shares for the foreseeable future and any decision to do so will be made by our board of directors in light of our earnings, financial position, capital requirements, credit agreements, legal requirements and other such factors as our board of directors deems relevant.
14
Table of ContentsITEM 6. SELECTED FINANCIAL DATA The following Selected Financial Data table sets forth our selected historical consolidated financial data for each of the fiscal years in the five-year period ended March 31, 2006, which were derived from our audited consolidated financial statements. The following data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and related notes included elsewhere in this Annual Report.
Note: Certain prior year amounts have been reclassified to conform with the current year presentation.
15
Table of ContentsFootnotes to “SELECTED FINANCIAL DATA”
16
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Based on revenue, Danka Business Systems PLC (also referred to herein as “Danka”, the “Company”, “we”, “us” or “our”) is one of the largest independent providers of print products and services in the United States and Europe/Australia. This includes the provision of office imaging equipment, document solutions and related services and supplies with the objective of assisting in the management of our customers’ print network and print output requirements to manage efficiencies in their businesses. We offer a wide range of state of the art office imaging products, peripherals and solutions that primarily include digital and color copiers, digital and color multi-function peripherals (“MFPs”), facsimile machines, printers and software. We also provide a wide range of contract services, including professional and consulting services, maintenance, supplies, leasing arrangements, technical support and training on the installed base of equipment created primarily by our retail equipment and related sales. Danka’s mission is to deliver value to clients worldwide by using our expert sales, technical and professional services and products to implement effective document information solutions and services. Our product portfolio is designed to provide our customers with choice, convenience, custom cost management and continuity. Our vision is to empower our customers to benefit fully from the convergence of image and document technologies in a connected environment. This approach will strengthen our client relationships and expand Danka’s strategic value. Our strategy to accomplish our mission is to:
We currently operate in over 15 countries. Our reportable segments are the United States and Europe/Australia, which include operations that are experiencing political, social and/or economic difficulty. We continue to evaluate the viability and future prospects of the operations in certain countries in light of uncertain conditions. Based on these evaluations, we sold our operations in Canada and Central and South America during fiscal year 2006, and we sold our operations in Portugal and Russia during fiscal year 2005. Should we decide to downsize or exit any of our other operations in the future, we could incur costs in respect of severance and closure of facilities and we may also be required to realize cumulative translation losses and minimum pension liabilities that would reduce our earnings, all or any of which may have a material impact on our operating results. All tables presented herein are in thousands unless otherwise noted. Critical Accounting Policies and Estimates In preparing our consolidated financial statements and accounting for the underlying transactions and balances, we apply various accounting policies. We consider the policies discussed below as critical to understanding our consolidated financial statements, as their application places the most significant demands on management’s judgment, since financial reporting results rely on estimates of the effects of matters that are inherently uncertain. Specific risks associated with these critical accounting policies are discussed throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) where such policies affect our reported and expected financial results. Allowance for Doubtful Accounts—We provide allowances for doubtful accounts and allowances for billing disputes and inaccuracies on our accounts receivable as follows:
17
Table of ContentsThe following table summarizes our net accounts receivable:
Inventories—We acquire inventory based on our projections of future demand and market conditions. Any unexpected decline in demand and/or rapid product improvements or technological changes may cause us to have excess and/or obsolete inventories. We have provided an appropriate estimate of reserves against these inventory items in current and prior periods. On an ongoing basis, we review for estimated obsolete or unmarketable inventories and write-down our inventories to their estimated net realizable value based upon our forecasts of future demand and market conditions using historical trends and analysis. If actual market conditions are less favorable than our forecasts due, in part, to a greater acceleration within the industry to digital office imaging equipment, additional inventory write-downs may be required. Our estimates are influenced by a number of considerations including, but not limited to, the following: decline in demand due to economic downturns, rapid product improvements and technological changes, and our ability to return to vendors a certain percentage of our purchases. Revenue Recognition—We generally have agreements to provide product maintenance services for the equipment that we sell or lease to customers. We follow the guidance in the Emerging Issues Task Force (“EITF”) Issue 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”), as modified for the impact of higher level accounting literature, to allocate revenue received between the two deliverables in the arrangement – the equipment and the product maintenance services. For arrangements in which the product maintenance services meet the definition in the Financial Accounting Standards Board (“FASB”) Technical Bulletin (“TB”) No. 90-1, “Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts” (“TB 90-1”), of a separately priced product maintenance contract, revenue equal to the amount paid by the customer to obtain the product maintenance services is allocated to the separately priced maintenance agreement, with the remainder of the revenue allocated to the equipment (or operating lease payments for use of the equipment). For arrangements in which the product maintenance services does not meet the definition in TB 90-1 of a separately priced product maintenance contract, but the revenue recognized related to the equipment is governed by FASB Statement No. 13, “Accounting for Leases” (“SFAS 13”), revenue is allocated between the equipment (or operating lease payments for use of the equipment) and product maintenance services on a relative fair value basis using our best estimate of fair value of the equipment (or operating lease payments for use of the equipment) and of the product maintenance services. Revenue from wholesale and retail equipment and related sales, including revenue allocated to equipment sales as discussed above, is recognized upon acceptance of delivery by the customer. In the case of equipment sales financed by third party finance/leasing companies, revenue is recognized at the later of acceptance of delivery by the customer or credit acceptance by the finance/leasing company. In addition, for the sale of certain digital equipment that requires a comprehensive setup by us before it can be used by a customer, revenue is recognized upon the customer’s written confirmation of delivery and installation. Supply sales to customers are recognized at the time of shipment unless supply sales are included in a service contract, in which case supply sales are recognized upon equipment usage by the customer. We sell equipment with embedded software to our customers. The embedded software is not sold separately, is not a significant focus of the marketing effort, and we do not provide post contract customer support specific to the software or incur significant costs that are within the scope of FASB Statement No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed” (SFAS 86”). Additionally, the functionality that the software provides is marketed as part of the overall product. The software embedded in the equipment is incidental to the equipment as a whole such that FASB Statement of Position No. 97-2, “Software Revenue Recognition” (“SFAS 97-2”), is not applicable. Revenue from the sales of equipment subject to an operating lease, or of equipment that is leased by or intended to be leased by the purchaser to another party, and sales-type leases is recognized in accordance with SFAS 13. Revenue from all other sales of equipment is recognized in accordance with SEC Staff Accounting Bulletin No. 104. Rental operating lease income is recognized straight-line over the lease term. Retail service revenues are generally recognized ratably over the term of the underlying product maintenance contracts. Under the terms of the product maintenance contract, the customer is billed a flat periodic charge and/or a usage-based fee. The typical agreement includes an allowance for a minimum number of copies for a base service fee plus an overage charge for any copies in excess of the minimum. We record revenue each period for the flat periodic charge and for actual or estimated usage. Cost of Sales—Inbound freight charges are included in inventory. When the inventory is sold, the cost of the inventory, including the inbound freight charges, is relieved and charged to costs of sales. When the inventory is rented, the cost of the inventory, including the inbound freight charges, is relieved and transferred to the rental equipment asset account. The cost of the rental equipment asset is then depreciated over the estimated useful life of the equipment. The depreciation of rental equipment assets is included in rental costs.
18
Table of ContentsPurchasing and receiving costs, inspection costs, warehousing costs and other distribution costs are included in selling, general and administrative costs because no meaningful allocation of these expenses to equipment, supplies, rental and wholesale costs of sales is practicable. Accordingly, our gross margins may not be comparable to other companies, since some companies include all of the costs related to their distribution network in cost of sales, while others exclude a portion of them from gross margin, including them instead in operating expense line items. These costs totaled $26.8 million and $28.0 million for fiscal years 2006 and 2005, respectively. We receive vendor rebates based on arrangements with certain equipment vendors. Those arrangements typically require vendors to make incentive payments to the Company based on the volume of periodic purchases (dollar amounts, quantity of specific units, etc.). Such rebates are accrued when purchases are made and can be reasonably estimated, recorded as reductions of inventory costs when accrued and recognized as a reduction to cost of sales when the related inventories are sold. Deferred Income Taxes—As part of the process of preparing our consolidated financial statements, we have to determine our income and corporation taxes in each of the taxing jurisdictions in which we operate. This process involves determining our actual current tax expense and loss carryforwards together with assessing any temporary differences resulting from the different treatment of certain items, such as the timing for recognizing revenues and expenses for tax and accounting purposes. These differences and loss carryforwards result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. In assessing the realizability of deferred tax assets, management considers whether it is “more likely than not” that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Our past financial performance is a significant factor which contributes to our inability, pursuant to FASB Statement No. 109, “Accounting for Income Taxes” (“SFAS 109”), to use projections of future taxable income in assessing the realizability of deferred tax assets. Management therefore is limited to considering the scheduled reversal of deferred tax liabilities and tax planning strategies in making this assessment. Considering all relevant data, management concluded that it is not “more likely than not” we will realize the benefits of the deferred tax assets at March 31, 2006. Consequently, we have a valuation allowance against net deferred tax assets in most jurisdictions at March 31, 2006. In addition, we operate within multiple taxing jurisdictions and are subject to audit in these jurisdictions. These audits can involve complex issues, which may require an extended period of time to resolve. In management’s opinion, adequate provisions for income and corporation taxes have been made for all years. Goodwill—We had goodwill of $206.2 million as of March 31, 2006. We review our goodwill and indefinite-lived intangible assets annually for possible impairment, or more frequently if impairment indicators arise in accordance with FASB Statement No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). Separable intangible assets that have finite lives are amortized over their estimated useful lives. Goodwill was reviewed for possible impairment during each of the fourth quarters of our fiscal years 2006 and 2005, in accordance with SFAS 142. In performing our impairment testing, we engaged an independent appraisal company to assist in the valuation of our reporting units. The fair values of the reporting units were determined using a combination of a discounted cash flow model and a guideline company method using valuation multiples. The discounted cash flow model used estimates of future revenue and expenses for each reporting unit as well as appropriate discount rates, and the estimates that were used are consistent with the plans and estimates the Company is using to manage the underlying business. Based on the analysis at January 1, 2005, management determined that the goodwill balance was impaired for its Europe/Australia reporting unit. As such, additional goodwill impairment testing was completed for that reporting unit, and based on the result of that testing, we recorded an impairment charge totaling $70.9 million during the fourth quarter of fiscal year 2005. No such charge was needed for fiscal year 2006. Accounting for Stock Based Compensation—As permitted by FASB Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), we account for our stock option plans under the intrinsic value recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations. As the exercise prices of all options granted under these plans were equal to the market price of the underlying American Depositary Shares (“ADS”) on the grant date, $0.2 million stock-based employee compensation expense was recognized in net earnings related to the issuance of shares to our Board of Directors pursuant to the 2002 outside Director Stock Compensation Plan. In general, these options expire in ten years and vest over three years. The proceeds from options exercised are credited to shareholders’ equity (deficit), net of related tax benefits. For current disclosure purposes, we compute the impact to earnings (loss) of stock-based compensation using the Black-Scholes option pricing model. SFAS 123 allows the use of option pricing models that were not developed for use in valuing employee stock options. In December 2004, the FASB issued FASB Statement No. 123R, “Share-Based Payment” (“SFAS No. 123R”), an amendment of SFAS 123. SFAS 123R eliminates the ability to account for share-based payments using APB 25 and instead requires companies to
19
Table of Contentsrecognize compensation expense using a fair-value based method for costs related to share-based payments, including stock options. The expense will be measured as the fair value of the award at its grant date based on the estimated number of awards that are expected to vest, and recorded over the applicable service period. In the absence of an observable market price for a share-based award, the fair value would be based upon a valuation methodology that takes into consideration various factors, including the exercise price of the award, the expected term of the award, the current price of the underlying shares, the expected volatility of the underlying share price, the expected dividends on the underlying shares and the risk-free interest rate. The requirements of SFAS 123R are effective for our fiscal year beginning April 1, 2006. Early adoption of the provisions of SFAS 123R is encouraged, but not required. The Company has elected the modified retrospective method of applying SFAS 123R. At meetings held on January 30 and 31, 2006, our Human Resources Committee of the Board of Directors and our Board of Directors approved the acceleration of the vesting of all of our stock options outstanding as of January 31, 2006. The acceleration of the options took place on March 15, 2006. The purpose of the accelerated vesting was to enable us to avoid recognizing in our income statement compensation expense associated with these options in future periods, due to the adoption of SFAS No. 123R. The pre-tax charge to be avoided upon adoption of SFAS 123R is expected to be approximately $2.1 million and represents the fair value of the unvested awards as of the date of the acceleration as determined under SFAS 123. As a result of the accelerated vesting, approximately 1.3 million shares with varying remaining vesting schedules became immediately exercisable. In order to help avoid unintended personal benefits to holders of the accelerated options, any shares received through exercise of accelerated options may not be sold by the option holder until the original vesting date of the accelerated option or the termination of the employment of the option holder, whichever occurs first. In connection with the accelerated vesting, each option agreement underlying such options was amended. As a result of the accelerated vesting of the options, we recorded an immaterial charge to earnings under APB 25. We expect the adoption of SFAS 123R will have an unfavorable impact for all future grants on our consolidated results of operations and net earnings (loss) per common share. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current guidelines. This requirement may reduce our net operating cash flows and increase net financing cash flows in periods after adoption. We cannot estimate what those amounts will be in the future because they depend on, among other things, when employees exercise stock options. All grants after March 31, 2006 will be valued using a binomial pricing model and we will recognize the associated expense over the vesting period based on the fair values determined by the binomial pricing model using the accelerated attribution method. Restructuring Charges—We recognized restructuring charges for the consolidation of back office functions, exiting non-strategic real estate facilities and reducing headcount. These charges are recorded pursuant to formal plans developed and approved by management. These charges are accounted for under the provisions of FASB Statement No. 112, “Employers’ Accounting for Postemployment Benefits” (“SFAS 112”) and FASB Statement No. 146, “Accounting for Cost Associated with Exit or Disposal Activities” (“SFAS 146”) and the recognition of restructuring charges requires that we make certain judgments and estimates regarding the nature, timing and amount of costs associated with these plans. The estimates of future liabilities may change, requiring additional restructuring charges or the reduction of liabilities already recorded. At the end of each reporting period, we evaluate the remaining accrued balances to ensure that no excess accruals are retained and the utilization of the provisions are for their intended purpose in accordance with the restructuring programs. For further discussion of our restructuring programs, refer to Note 3. “Restructuring Charges (Credits)” to the Consolidated Financial Statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.” Controls and Procedures Management assessed the effectiveness of our internal control over financial reporting as of March 31, 2006. Based upon this assessment and as more fully explained in Item 9A-Controls and Procedures, management identified a material weakness in our internal control over financial reporting as of March 31, 2006 related to our revenue and billing process. During the testing phase, management began developing remediation plans and is in the process of finalizing those plans. Once remediation plans are finalized, timelines (where determinable) will be established to complete those plans. Financial Condition
Total assets as of March 31, 2006 decreased $140.2 million or 18.2% from March 31, 2005. This decrease was due to several factors, including the sale of our Canadian and Central and South American subsidiaries which reduced assets held for sale by $44.9 million.
20
Table of ContentsAccounts receivable decreased $22.1 million resulting from improved collections and decreasing revenue. In addition, cash decreased $22.5 million to fund operations, and fixed assets and rental assets decreased $19.1 million due to continuing depreciation of assets and decreased capital spending on rental assets during fiscal year 2006. Total liabilities decreased $70.7 million from March 31, 2005, or 10.3%. This decrease was also due to several factors including the sale of our Canadian and Central and South American subsidiaries which reduced liabilities held for sale by $16.5 million, and a decrease in accrued expenses of $28.3 million due to the payout of restructuring accruals of $20.2 million and payouts of other accrued professional fees of $8.7 million (primarily related to our Sarbanes Oxley compliance efforts during fiscal year 2005). Taxes payable decreased by $15.0 million due to favorable resolutions of tax contingenies. These decreases in liabilities were offset by an increase in our borrowings on our credit facility which totaled $10.0 million at the end of fiscal year 2006. Working capital, defined as current assets less current liabilities, decreased $44.3 million from March 31, 2005 primarily resulting from the sale of our Canadian and Central and South American subsidiaries discussed above. Liabilities to liabilities and capital increased 9% at March 31, 2006 compared to March 31, 2005 due to operating losses during fiscal year 2006. For the period ending March 31, 2006, our annualized inventory turnover ratio remained stable at 5x.
21
Table of ContentsRESULTS OF OPERATIONS The following table sets forth for the periods indicated the percentage of total revenue represented by certain items in our Consolidated Statements of Operations:
The following table sets forth for the periods indicated the change in our revenue from the prior year:
The following table sets forth for the periods indicated the gross profit margin percentage for each of our revenue classifications:
The following tables set forth for the periods indicated the revenue, gross profit, operating earnings (loss) from continuing operations, interest expense, capital expenditures, depreciation and amortization, assets and long-lived assets for each of our operating segments. We have not aggregated any of our operating segments. During fiscal year 2006, our operating segments were the United States and Europe/Australia, both of which were organized based on geographic areas. Our chief operating decision maker relies on an internal management reporting process that provides segment revenue and earnings from operations as shown in our consolidated statement of operations. The operations of these operating segments are regularly reviewed, through discrete financial information that is available by our chief operating decision maker to make decisions about resources to be allocated to the segment and to assess its performance. We believe this is an appropriate measure of evaluating the operating performance of our business.
22
Table of ContentsRevenue, Gross profit, Operating earnings (loss) from continuing operations and Interest expense
Approximately 52.3%, 52.0% and 48.5% of our revenue in fiscal years 2006, 2005 and 2004, respectively, was generated outside the United States. Capital Expenditures and Depreciation and Amortization
23
Table of ContentsAssets and Long-lived Assets
The following table sets forth for the periods indicated the percentage of growth (decline) of total revenue for each of our operating segments:
The following tables set forth for the periods indicated the gross profit margin percentage and operating earnings (loss) from continuing operations margin as a percentage of sales for each of our operating segments:
Fiscal Year 2006 Compared to Fiscal Year 2005 Revenue Revenue includes customer purchases of office peripherals; professional, consulting and maintenance services; supplies; software and related support products; and leasing arrangements. For fiscal year 2006, our revenue decreased by $70.8 million or 6.1% from fiscal year 2005, with the United States segment decreasing $37.5 million or 6.7% and Europe/Australia decreasing $33.3 million or 5.5%. Service revenues continued to decrease due in part to the continued conversion from analog devices to digital devices and a shift and decline in certain segments of our installed base. In addition, we are experiencing decreases in our click rates (per copy charge) due to competitive pricing pressures and slower than expected growth in service volume from newer printer manufacturer customers. Our retail equipment and related sales increased slightly due to higher unit placements during the year. This increase was offset by increased pricing pressures coupled with product portfolio gaps (including our 50 page per minute color machine offerings) and other weaknesses in certain areas of our Europe/Australia business, most notably, the United Kingdom. These issues, combined with the advent of other competitive equipment from printer manufacturers, may continue to hinder our progress in growing our retail equipment and related sales revenue.
24
Table of ContentsOur revenue for fiscal year 2006 was negatively impacted by $33.1 million of foreign currency movement. During the year, 47.7% of our total revenue was generated by our United States segment and 52.3% by our Europe/Australia segment, compared to 48.0% and 52.0% respectively, during fiscal year 2005. Retail equipment and related sales for fiscal year 2006 increased by $0.7 million or 0.2% to $423.0 million compared to the prior period. The United States was up $2.1 million or 0.9% due to increased sales productivity as a result of a realignment of our sales force towards a more market-based approach. This increase was offset by increasing pricing pressures and product portfolio gaps. Retail equipment and related sales revenue in the Europe/Australia segment was down $1.3 million or 0.7%. This decrease was the result pricing pressures and a negative foreign currency movement of $11.1 million or 5.7%. These decreases were offset by higher placement of units during the year. Retail service revenue declined by $58.2 million or 10.4% to $498.8 million due largely to the factors discussed above. The United States was down $34.5 million or 11.7%. This decrease in the United States was largely due to lower average per copy charges as a result of pricing pressures which are inhibiting price maintenance increases on renewals and new contracts. Retail service revenue in the Europe/Australia segment was down $23.7 million or 9.0%. In Germany, France, the Netherlands and the United Kingdom, where we are also faced with declines in per copy charges related to the transition from analog and early digital devices to more current models. This decrease included a negative foreign currency movement of $13.9 million or 5.3%. Retail supplies and rental revenue declined by $12.0 million or 12.9% to $80.7 million in fiscal year 2006 with the United States segment down $5.0 million or 13.0%. This decline was primarily due to non-investment in rental equipment. In addition, renewal negotiations with certain governmental agencies were not completed during the fiscal year resulting in the inability to record $2.4 million of rental revenue during the current fiscal year. Retail supplies and rental revenue in the Europe/Australia segment was down $6.9 million or 12.9%. The decrease in supplies is a result of the trend in the United Kingdom where color machine service contracts are moving from being exclusive to inclusive of toner supplies and thus the related revenue is moving from supplies to service. This decrease included a negative foreign currency movement of $2.0 million or 3.8%. Wholesale revenue declined by $1.3 million or 1.4% to $93.5 million, due in part to pricing pressures. During fiscal year 2005, we changed the IT platform in our European wholesale business to Oracle and moved the physical location of the administration center. While these changes in the long term will provide a much improved infrastructure for our wholesale business, in the short term, they negatively impacted our ability to accept, process and deliver customer orders during fiscal year 2005 and resulted in customer erosion. As a result of this improvement, we did have higher placement of units during fiscal year 2006. This increase was offset by a negative foreign currency movement of $6.1 million or 6.4%. Gross Profit Our total gross profit margin after costs of goods sold, which primarily includes inventory, service labor and overhead, management costs and depreciation of equipment, decreased to 31.9% in fiscal year 2006 from 34.6% in the year-ago period. Our total gross profit decreased $9.8 million due to foreign currency movements during the year. The gross profit margin for the United States segment decreased to 34.2% from 37.2% and the Europe/Australia segment decreased to 29.7% from 32.2% in the year-ago period. Retail equipment and related sales margins decreased to 29.9% from 33.1% in the year-ago period. Margins decreased in the Europe/Australia due to market pricing pressures and unfavorable product mix. In addition, there have been increased market pressures in certain product offerings. Retail equipment and related sales margins decreased in the United States due to increased price competition and a product gap, primarily in our high volume color segment. This has led to discounting of products with more functionality to fill the product portfolio gaps. Retail service margins decreased to 35.4% from 38.1% in the year-ago period. In the United States, the margins decreased from 40.4% to 37.7%, and in Europe/Australia the margins decreased from 35.6% to 32.9%. Generally, the decrease in retail service margins was due to the fixed cost element of the service business, combined with lower revenue, and the decision to retain rather than reduce service personnel in anticipation of future service business with certain customers. In addition, service revenues were impacted by the slower than expected ramp up of some of our printer manufacturer contracts combined with start up costs incurred to generate these contracts. Retail supplies and rental margins decreased to 36.8% from 37.6% in the year-ago period. In the United States, the margin decreased due to continuing depreciation being taken for rental equipment on contracts with certain governmental customers for which revenues have not been recognized in the current fiscal year as there had been delays in executing purchase orders by those customers as discussed above. Wholesale margins remained stable year over year.
25
Table of ContentsSelling, General and Administrative Expenses Selling, general and administrative expenses (“SG&A”) during fiscal year 2006 decreased by $77.8 million or 17.7% from the year-ago period to $361.0 million from $438.8 million. As a percentage of total revenue, SG&A expenses decreased to 32.9% in the current year from 37.6% in the prior year. This decline reflects the success of our Vision 21 reengineering initiative, including significant headcount reductions and reduced facility costs. As part of this initiative in the United States, we have outsourced several of our general and administrative functions which have introduced a variable cost element in certain support operations which have historically been part of our fixed costs. This approach has enabled the reduction of our overall costs. In addition, the costs associated with compliance with the Sarbanes Oxley Act of 2002 has decreased by $7.7 million year over year. Foreign currency movement decreased SG&A by $9.0 million or 2.0%. Restructuring Charges (Credits) In fiscal years 2005 and 2004, we formulated plans to continue to eliminate inefficiencies in our field operations and to reduce our SG&A costs by eliminating and consolidating back office functions and exiting certain facilities. As part of these plans, during fiscal year 2006, we recorded a $12.5 million restructuring charge comprised of severance charges of $13.9 million due to additional cost reduction efforts and $2.3 million of facility charges due to additional facility closures. These charges were offset by a reduction in severance charges of $3.6 million due to favorable severance negotiations and employee attrition. During the year-ago period, we took a restructuring charge of $9.7 primarily relating to severance charges under the fiscal year 2005 restructuring plan. Impairment Charges Goodwill was reviewed for possible impairment as of January 1, 2006 and 2005, in accordance with SFAS No. 142. In performing our impairment testing, we engaged an independent appraisal company to assist in the valuation of our reporting units. The fair value of the reporting units were determined using a combination of a discounted cash flow model and a guideline company method using valuation multiples. The discounted cash flow model used estimates of future revenue and expenses for each reporting unit as well as appropriate discount rates, and the estimates that were used are consistent with the plans and estimates we are using to manage the underlying business. Based on the analysis at January 1, 2005, management determined that the goodwill balance was impaired for its Europe/Australia reporting unit. As such, additional goodwill impairment testing was completed for that reporting unit, and based on those results, we recorded an impairment charge totaling $70.9 million during fiscal year 2005. No such charge was needed during fiscal year 2006. Other (Income) Expense Other expense decreased $0.2 million year over year primarily due to a loss of $1.1 million associated with the disposal of our subsidiaries in Portugal and Russia in the prior year period. Operating Earnings (Loss) from Continuing Operations Our operating loss from continuing operations was $24.7 million for fiscal year 2006 compared to a loss of $116.1 million in the prior year period. During fiscal year 2005, we recorded an impairment charge of $70.9 million. This decrease in operating loss was further attributable to the decreases in SG&A, offset by lower sales and our lower gross margins as discussed above. Interest Expense and Interest Income Interest expense and interest income remained relatively stable for fiscal year 2006 at $31.7 million and $0.1 million, respectively. Income Taxes We recorded an income tax benefit of $9.1 million in the fiscal year 2006 compared to a tax benefit of $21.9 million in the prior year period. The tax benefit for the current period is primarily related to favorable resolution of tax contingencies in the United States partially offset by tax accruals for operating profits in certain European jurisdictions. In the prior period, the tax benefit was primarily related to a favorable audit settlement in our European operations, partially offset by the recording of additional audit reserves in the United States and the accrual of minimum taxes for certain jurisdictions. We did not recognize tax benefits on current or prior year operating losses due to the uncertainly associated with ultimate utilization.
26
Table of ContentsNet Earnings (Loss) from Continuing Operations Net loss from continuing operations was $47.4 million in fiscal year 2006, compared to a net loss from continuing operations of $125.7 million in the year-ago period. After allowing for the dilutive effect of dividends on our participating shares, we incurred net loss from continuing operations attributable to common shareholders of $1.08 per ADS during the current period compared to a net loss from continuing operations of $2.31per ADS in the year-ago period. Fiscal Year 2005 Compared to Fiscal Year 2004 Revenue In fiscal year 2005, our revenue decreased by $88.6 million or 7.1% from fiscal year 2004, with the United States segment decreasing $86.1 million or 13.3% and Europe/Australia down $2.5 million or 0.4%. This decrease was the result of a decline in retail service revenue due to a decline in machines in field (“MIF”) and lower average monthly copy and usage values due to the continuing industry-wide conversion from analog to digital equipment; a decline in overall sales coverage in our United States operations due to restructuring efforts aimed at reducing our cost structure; and a decline in retail equipment and related sales revenue from our United States Enterprise and National Accounts. Our revenue for fiscal year 2005 was positively impacted by $41.1 million of foreign currency movement. During fiscal year 2005, 48.0% of our total revenue was generated by our United States segment and 52.0% by our Europe/Australia segment, compared to 51.5% and 48.5%, respectively, during fiscal year 2004. Our fiscal year 2005 retail equipment and related sales declined by $20.9 million or 4.7% to $422.3 million in fiscal year 2005 compared to fiscal year 2004, with the United States down $25.4 million or 10.1%. This decrease in the United States is the result of declining revenue streams from our Enterprise and National Accounts sales channels due to the maturation of existing accounts and increased competition in these channels. Retail equipment and related sales revenue in the Europe/Australia segment was up $4.6 million or 2.4%. This increase in the Europe/Australia segment is attributed to positive foreign currency movements of $13.1 million or 6.9% during the year. Retail service revenue declined by $51.2 million or 8.4% to $557.0 million due largely to the decrease in retail equipment and related sales, lower MIF and lower usage volume. The United States segment was down $47.8 million or 14.0%. This decrease in the United States is a direct result of the continued decline in our MIF and a decline in our average monthly per machine copy volumes. During fiscal year 2004, we strategically reduced the number of service personnel in the field which caused some declines in our MIF and the revenue therefrom. Retail service revenue in Europe/Australia was down $3.5 million or 1.3%. Revenues declined $21.4 million primarily due to ongoing service declines in the UK, Germany and France as a result of reduced MIF and a de-emphasis on rental investments. This decrease was partially offset by a positive foreign currency movement of $17.9 million or 6.7%. Retail supplies and rental revenue declined by $14.1 million or 13.2% to $92.7 million. The decline in our revenue was primarily due to the transition in our industry from analog to digital products and the resulting lower retail placements, reduced MIF, increased competition as a result of technology convergence, such as the advent of Multifunctional peripherals (“MFPs”), and an increase in the migration of copy volume from copiers to network printers and weaker global economic conditions which resulted in reduced or delayed capital spending by customers. Retail supplies and rental revenues in the United States was down $12.9 million or 25.1% in fiscal year 2005. Supplies decreased in the United States segment primarily due to the decline in our Kodak analog base. The Kodak base uses a proprietary supply product and that page volume is rapidly moving to digital, a natural but negative consequence of the analog to digital transition. Rental revenue decreased due to strategic initiatives to de-emphasize investment in rental equipment as leases expire, and our lack of investment in new rental placements is likely to continue downward pressure in these revenue streams. This initiative reduces cash outlays for such equipment. Retail supplies and rental revenue in Europe/Australia was down $1.1 million or 2.0%. This decrease in total retail supplies and rental revenue for the Europe/Australia segment was primarily due to our strategic initiatives to de-emphasize investment in rental equipment as mentioned above. This decrease was partially offset by a positive foreign currency movement of $3.9 million or 7.0%. Wholesale revenue decreased $2.5 million or 2.6% during fiscal year 2005 to $94.8 million. During fiscal year 2005, we changed the IT platform of our wholesale business to Oracle and moved the physical location of the administration center. While these changes, in the long term, will provide a much improved infrastructure for our wholesale business, in the short term these changes have negatively impacted our ability to accept, process and deliver customer orders, which has resulted in lower sales.
27
Table of ContentsGross Profit Our total gross profit margin decreased to 34.6% in fiscal year 2005 from 36.6% in the year-ago period. The decrease in our gross profit margin is primarily due to a faster decline in our retail service revenue than our planned headcount reductions as part of our restructuring plans. Also during the year, our gross margins were negatively impacted by approximately $5.0 million due to a decrease in the amount of vendor rebates earned. The gross profit margin for the United States segment decreased to 37.2% from 40.8% and the Europe/Australia segment remained stable at 32.2%. Margins could continue to be impacted if we are not successful in slowing or reversing the declines in our retail equipment and retail service revenues. The retail equipment and related sales margin decreased to 33.1% from 34.1% in the year-ago period. Margins increased in our United States segment due to lower national and enterprise revenues which tend to have low margins. This increase was offset by lower Europe/Australia margins due to pricing competition and sales force turnover. Retail service margins decreased to 38.1% from 40.3% in the year-ago period primarily due to lower revenues offset by lower parts and labor costs. Retail supplies and rental margins decreased to 37.6% from 41.6%. Margins increases related to the de-emphasis on investment in rental equipment, which resulted in lower depreciation costs for the year. The increase was partially offset by a decrease in supplies margins in the United States due to the decline in our Kodak analog base which generally has higher margins. Wholesale margins decreased to 17.6% from 19.6% in the year-ago period due to a shift toward lower margin business in an effort to win back customer loyalty resulting from poor execution on deliveries to customers due to back office constraints. Our conversion to our Oracle system will help to alleviate these constraints, even though we experienced some difficulties due to the implementation of the system. Selling, General and Administrative Selling, general and administrative expenses (“SG&A”) increased by $11.8 million or 2.8% from the year-ago period to $438.8 million. SG&A increased due to Sarbanes-Oxley compliance costs of $13.5 million during fiscal year 2005, additional bad debt during the year of approximately $6.6 million, $3.0 million relating to other consulting services and a foreign currency movement which increased SG&A by 2.9% or $13.4 million. These increases were partially offset by ongoing cost reduction efforts and the progress in the implementation of our worldwide cost reduction program. The cost reduction program allowed us to reduce our compensation expense by approximately $22.5 million and lower our facility costs by approximately $8.6 million. As a percentage of total revenue, SG&A expenses increased to 37.6% from 34.0% due to lower revenues in fiscal year 2005. Restructuring Charges (Credits) In fiscal year 2005, we formulated plans to continue to eliminate inefficiencies in our field operations and to reduce our SG&A costs by eliminating and consolidating back office functions and exiting certain facilities. As part of these plans, we recorded a $12.2 million restructuring charge in fiscal year 2005 comprised of severance charges of $11.9 million and facility closure charges of $0.3 million. The fiscal year 2005 restructuring charge was partially offset by a $2.5 million reversal of prior years’ restructuring charges as a result of employee attrition and a change in restructuring plans offset by higher than originally estimated facility closure costs. In the third and fourth quarters of fiscal year 2004, we formulated plans to significantly reduce our SG&A costs by consolidating our back-office functions in the United States, exiting non-strategic real estate facilities and reducing headcount in the Americas and Europe/Australia. As part of those plans, we recorded a $47.3 million restructuring charge in fiscal year 2004 that included $24.1 million related to severance for employees and $23.2 million related to future lease obligations for facilities. The fiscal year 2004 restructuring charges were partially offset by a $0.6 million reversal of prior years’ restructuring charges. We expected to realize between $51 million and $56 million in connection with the fiscal year 2004 restructuring plan. Management believes substantially all of these savings have been realized through lower personnel and facility related costs during fiscal year 2005. Impairment Charges Goodwill was reviewed for possible impairment as of January 1, 2005, in accordance with SFAS 142. In performing our impairment testing, we engaged an independent appraisal company to assist in the valuation of our reporting units. The fair value of the reporting units were determined using a combination of a discounted cash flow model and a guideline company method using valuation multiples. The discounted cash flow model used estimates of future revenue and expenses for each reporting unit as well as appropriate discount rates, and the estimates that were used are consistent with the plans and estimates we are using to manage the underlying business. Based on the analysis at January 1, 2005, management determined that the goodwill balance was impaired for its Europe/Australia reporting unit. As such, additional goodwill impairment testing was completed for that reporting unit, and based on those results, we recorded an impairment charge totaling $70.9 million.
28
Table of ContentsOther (Income) Expense Other expense was $0.7 million compared to other expense of $2.3 million in the year-ago period. Other expense consisted primarily of a foreign currency gain of $0.5 million offset by a loss associated with the exit of our subsidiaries in Portugal and Russia of $0.7 million. Other expense for the prior year period included a $1.9 million write-off of trademark costs associated with the Kodak acquisition offset by a foreign currency gain of $0.1 million. Operating Earnings (Loss) from Continuing Operations The operating loss from continuing operations was $116.1 million in fiscal year 2005 versus losses of $16.6 million in fiscal year 2004. The decline in the operating loss from continuing operations was primarily due to the $70.9 million impairment charge and lower gross profit of $55.5 million, offset by lower restructuring charges in fiscal year 2005. Interest Expense and Interest Income Interest expense decreased by $2.3 million to $31.5 million. The decrease was due to a lower effective interest rate on our indebtedness in part because of the refinancing of our debt in July 2003. Income Taxes We recorded an income tax benefit of $21.9 million in fiscal year 2005 compared to tax expense of $43.5 million in the prior year period. The tax benefit in fiscal year 2005 was primarily related to a favorable audit settlement in our European operations partially offset by the recording of additional audit reserves in the United States and the accrual of minimum taxes for certain jurisdictions. The significant income tax provision in fiscal year 2004 was primarily due to an increase in our valuation allowance to fully reserve deferred tax assets on the balance sheet at March 31, 2004. Net Earnings (Loss) from Continuing Operations Our net loss from continuing operations was $125.7 million in fiscal year 2005 compared to a net loss of $113.7 million in fiscal year 2004. Our net loss from continuing operations in fiscal year 2005 was primarily due to the $70.9 million impairment charge, $9.7 million restructuring charge and lower gross profit of $55.5 million. Our net loss in fiscal year 2004 was due to the $46.7 million restructuring charge, the $20.6 million write-off of debt issuance costs, the $50.8 million write-off of deferred tax assets and the $44.3 million decrease in gross profit. After allowing for the dilutive effect of dividends on our participating shares, we incurred a net loss from continuing operations available to common shareholders of $2.31 per ADS in fiscal year 2005 compared to a net loss of $2.12 per ADS in fiscal year 2004. EXCHANGE RATES We operate in over 15 countries worldwide. Fluctuations in exchange rates between the United States dollar and the currencies in each of the countries in which we operate affect:
Our results of operations are affected by the relative strength of currencies in the countries where our products are sold. Approximately 52.3%, 52.0% and 48.5% of our revenue in fiscal years 2006, 2005 and 2004, respectively, was generated outside the United States. In comparing the average exchange rates between fiscal year 2006 and the year-ago period, the euro currency and the British pound sterling weakened against the United States dollar by approximately 6.4% and 7.9%, respectively. The change in exchange rates negatively impacted revenue by approximately $33.1 million, lowered gross profit by $9.8 million and lowered SG&A by $9.0 million. During fiscal year 2005, the euro and the British pound sterling strengthened against the United States dollar by approximately 9.1% and 7.0%, respectively. This positively impacted revenue by approximately $42.6 million, increased gross profit by $13.6 million and increased SG&A by $13.4 million Our inter-company loans are subject to fluctuations in exchange rates between the United States dollar and the currencies in each of the countries in which we operate, primarily the euro and the British pound sterling. Based on the outstanding balance of our inter-company loans at March 31, 2006, a change of 1% in the exchange rate for the euro and British pound sterling would cause a change in our foreign exchange result of less than $0.1 million. Our results of operations and financial condition have been, and in the future may be, adversely affected by the fluctuations in foreign currencies and by translation of the financial statements of our European subsidiaries, from local currencies to the United States dollar. Generally, we do not hedge our exposure to changes in foreign currency. Gains and losses included in the consolidated statements of operations from foreign currency transactions included a $0.4 million gain in fiscal year 2006, a $0.5 million gain in fiscal year 2005 and a $0.1 million gain in fiscal year 2004.
29
Table of ContentsLIQUIDITY AND CAPITAL RESOURCES The following table summarizes our cash flows from continuing operations for fiscal years 2006, 2005 and 2004 as reported in our Consolidated Statements of Cash Flows in the accompanying Consolidated Financial Statements:
Cash flows Our generation and use of cash is cyclical within a quarter. Typically, we generate a significant portion of our cash toward the end of each quarter where we typically conclude a large percentage of our retail equipment transactions while our use of cash is more evenly spread during the quarter after a greater use of cash toward the beginning of the quarter, when we typically pay vendors for products sold toward the end of the quarter and for other services provided during the quarter. During the third and fourth quarters of fiscal year 2006, we used our cash more evenly throughout the periods and have used cash to reduce our accounts payable and accrued expenses, which we expect will help improve the operation of our business. In the first and third quarter of every fiscal year, we make combined interest payments of $12.8 million for the 10.0% subordinated notes and the 11.0% senior notes. Generally, cash provided by operations and cash on the balance sheet continue to be our primary source of funds to finance operating needs and capital expenditures. Our net cash flow used in operating activities during fiscal year 2006 was $37.7 million. Our net cash flow provided by operating activities was $10.4 million and $61.2 million in fiscal years 2005 and 2004, respectively. The decrease in cash flows from operations during fiscal year 2006 is a result of the continuing decline in our revenues and the resulting decline in our gross profit, payouts of restructuring of $20.2 million, payouts of accrued professional fees of $8.7 million and reductions in other accrued expenses. These uses of cash were offset somewhat by improved collections of accounts receivable of $23.5 million. The decrease in cash flows during fiscal year 2005 is a result of declines in our revenues and declines in our gross profit. In addition, the $50.8 million decrease in fiscal year 2005 operating cash flow was primarily due to restructuring cash payments of $25.5 million and lower collections on accounts receivable as a result of lower revenues, partially offset by an increase in accounts payable. Our net cash flow provided by investing activities during fiscal year 2006 was $4.1 million while cash flow used in investing activities was $23.5 million and $29.0 million for fiscal years 2005 and 2004, respectively. Cash flow provided from investing activities during fiscal year 2006 resulted from cash generated from the sale of our operations in Canada and Central and South America offset by capital expenditures. Cash outflows during fiscal year 2005 for investing activities was primarily due to spending for property and equipment offset by the payment of $2.1 million for the acquisition of Image One, a regional print service provider. Fiscal year 2004 cash outlays from investing activities was primarily due to spending for property and equipment related, in part, to completion of the Vision 21 project and the new United States headquarters building. Our net cash flow provided by financing activities during fiscal year 2006 was $8.1 million while our net cash flow used in financing activities was $6.2 million and $5.1 million for fiscal years 2005 and 2004, respectively. During fiscal year 2006, we had borrowings of $10.0 million outstanding on our credit lines at the end of the year. During fiscal years 2005 and 2004, we had minimal financing activities, both in quantity and in amounts. The Company also has restricted cash of $20.5 million due to the cash collateralization of our line of credit with Bank of America and of certain letters of credit with ABN Amro and insurance companies. The ABN Amro letter of credit facility expired on December 31, 2005. As a result, beginning January 1, 2006, we were required to increase our cash collateralization of our letter of credit by Euro 6.8 million (U.S. $8.3 million) for a total of Euro 11.8 million (U.S. $14.3 million). We are currently working with several banks to obtain financing for the letter of credit. Our liquidity could also be impacted if our equipment vendors were to reduce existing lines of credit for the purchase of equipment
30
Table of ContentsWe believe cash and cash equivalents on hand, together with availability of our credit facility is sufficient to fund our cash requirements for the next twelve months. The next significant non-operating cash requirement for the Company is the repayment of $64.5 million of 10.0% subordinated notes due April 2008. The Company is exploring a range of strategic alternatives to meet this obligation. Restructuring Charges Fiscal Year 2005 Plan: In fiscal year 2005, we formulated plans to continue to eliminate inefficiencies in our field operations and to reduce our selling, general and administrative costs by eliminating and consolidating back office functions and exiting certain facilities. These charges were accounted for under the provisions of FASB Statement No. 112, “Employers’ Accounting for Postemployment Benefits” (“SFAS 112”) and FASB Statement No. 146, “Accounting for Cost Associated with Exit or Disposal Activities” (“SFAS 146”). As part of these plans, we recorded a $15.2 million restructuring charge in fiscal year 2006 primarily relating to severance charges due to additional cost reduction efforts. These charges were offset by a reduction in severance charges of $3.3 million due to favorable severance negotiations and employee attrition. Cash outlays for severance and facilities during the year were $10.4 million and $0.4 million, respectively. The other non-cash changes of $0.7 million represent foreign currency adjustments. The remaining liability of the 2005 Plan restructuring charge of $6.1 million and $4.6 million is categorized within “Accrued expenses and other current liabilities” and “Deferred income taxes and other long-term liabilities”, respectively. We estimated that this program would reduce operating expenses by $44 million to $51 million and cost of goods sold by $16.0 million to $22.0 million per year when fully implemented, and would result in a 12.0% decrease in worldwide workforce. To date, we believe we have met the targets to achieve these savings. The actions needed to achieve these savings had been taken in steps, beginning with the charges taken in fiscal year 2005 and were expected to require up to $37.0 million of cash. Our current estimate of cash required has been reduced to $28.0 million to $33.0 million in cash due to lower severance payouts than expected and favorable termination terms for facility leases. The payback on the cash is expected to be less than 12 months. The following table summarizes the fiscal year 2005 Plan restructuring charge: 2005 Plan Restructuring Charge:
2005 Plan Restructuring Severance Charge by Operating Segment:
2005 Plan Restructuring Facility Charge by Operating Segment:
31
Table of ContentsFiscal Year 2004 Plan: In fiscal year 2004, we formulated plans to significantly reduce our selling, general and administrative costs by consolidating the back-office functions in the United States, exiting non-strategic real estate facilities and reducing headcount in the United States and Europe/Australia. These charges were accounted for under the provisions of SFAS 112 and SFAS 146. As part of these plans, we recorded a $47.3 million restructuring charge in fiscal year 2004 that included $24.1 million related to severance for employees and $23.2 million related to future lease obligations for facilities that were vacated by March 31, 2004. The fiscal year 2004 restructuring charge was partially offset by $0.6 million reversal of prior years’ restructuring charges. We reversed $2.0 million of fiscal year 2004 Plan severance and facility charges during fiscal year 2005 as a result of employee attrition in its United States and Europe/Australia segments, and a change in restructuring plans in Europe/Australia due to improved performance in certain markets partially offset by a higher estimate of facility charges in the United States due to our inability to sublease the facilities. Cash outlays for employee severance during fiscal year 2006 were $2.2 million. In addition, we reversed $0.3 million of severance costs during the period due to employee attrition. The remaining non-cash change of $0.1 million represents foreign currency adjustments. Cash outlays for facilities for fiscal year 2006 were $7.1 million. We incurred $0.9 million of fiscal year 2004 Plan facility charges during fiscal year 2006, as a result of broker commissions paid in the United States due to the sub-lease of certain facilities. If remaining leases are not terminated, payments will continue through their respective terms. The remaining liability of the 2004 Plan restructuring charge of $4.0 million and $2.6 million is categorized within “Accrued expenses and other current liabilities” and “Deferred income taxes and other long-term liabilities”, respectively. We expected to realize savings between $51 million and $56 million in connection with the fiscal year 2004 restructuring plan. Management believes substantially all of these savings were realized through lower personnel and facility related costs during fiscal years 2006 and 2005. The following table summarizes the fiscal year 2004 Plan restructuring charge: 2004 Plan Restructuring Charge:
2004 Plan Restructuring Severance Charge by Operating Segment:
32
Table of Contents2004 Plan Restructuring Facility Charge by Operating Segment:
Debt The following table sets forth our future payments for our debt:
The 10.0% subordinated notes due April 1, 2008 require interest payments of $3.2 million every six months on April 1 and October 1. The 11% senior notes have a fixed annual interest rate and require interest payments of $9.6 million every six months on June 15 and December 15. The senior notes mature on June 15, 2010. The senior notes are fully and unconditionally guaranteed on a joint and several basis by our Australian subsidiaries, a Luxembourg subsidiary, two United Kingdom subsidiaries, one of which is our primary United Kingdom operating subsidiary, and all of our United States subsidiaries other than certain dormant entities, all of which are 100% owned by us. If, for any fiscal year commencing with the fiscal year ended March 31, 2004, there is excess cash flow, as such term is defined in the indenture governing the senior notes, in an amount in excess of $5.0 million, we will be required to make an offer in cash to holders of the senior notes to use 50.0% of such excess cash flow to purchase their senior notes at 101.0% of the aggregate principal amount of the senior notes to be repurchased plus accrued and unpaid interest and additional amounts, if any. As of March 31, 2006, there has not been excess cash flow for any fiscal year. We incurred $7.2 million in debt issuance costs relating to the senior notes and are amortizing these costs over the term of the senior notes. The balance of these costs as of March 31, 2006 was $4.4 million. The $4.1 million discount related to the senior notes is being accreted to interest expense using the effective interest method over the life of the related debt. The balance of the discount as of March 31, 2006 was $2.8 million. We have a credit facility which expires on January 4, 2008, with Bank of America, which acquired Fleet Capital Corporation, (the “Fleet Credit Facility”) to provide a $50.0 million, senior secured revolving credit facility, which includes a $30.0 million sub-limit for standby and documentary letters of credit. The Fleet Credit Facility bears interest at an annual rate equal to, at our option, (a) the sum of the rate of interest publicly announced from time to time by Bank of America as its prime or base rate of interest plus the applicable margin thereon or (b) the sum of LIBOR for interest periods at our option of one, two, three or nine months plus the applicable margin thereon. Under the terms of the Fleet Credit Facility, as amended, extensions of credit are further limited to the lesser of the commitment and the borrowing base. In addition, the Fleet Credit Facility requires us to keep $5.0 million of cash in an operating account. During fiscal year 2006 our borrowings under the Credit Fleet Facility ranged between $5 million and $13 million at any one time. As of March 31, 2006, the borrowing base for the credit facility was $40.4 million and we had borrowings of $10.0 million under the Fleet Credit Facility. The borrowing base fluctuates each month and is generally highest at the end of the quarter. We incurred $1.6 million in debt issuance costs relating to the Fleet Credit Facility and are amortizing these costs over the remaining term of the credit facility. The balance of these costs as of March 31, 2006 was $0.5 million. On December 31, 2003, we entered into a one year letter of credit facility with ABN Amro. On November 2, 2004, this agreement was amended to provide us a letter of credit facility for Euro 11.8 million (U.S. $14.3 million) and an open term credit facility of Euro
33
Table of Contents1.0 million (U.S. $1.2 million) available for general working capital purposes, including overdrafts. The open term credit facility expired on November 15, 2005. The letter of credit facility expired on December 31, 2005. The facilities were secured by the assets of certain of our Netherlands subsidiaries and were also cash collateralized by Euro 5.0 million (U.S. $6.1 million). On January 1, 2006, we opened a replacement letter of credit facility with ABN AMRO in the amount of Euro 11.8 million (U.S. $14.3 million) that is fully cash collateralized and will expire on June 30, 2006. This agreement can be renewed. The Company is currently working with several banks to obtain financing for this letter of credit. Credit Ratings
Our ability to obtain financing and the related cost of borrowing is affected by our debt ratings, which are periodically reviewed by the major credit rating agencies. Our current credit ratings are below investment grade and we expect our access to the public debt markets to be limited to the non-investment grade segment. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements as defined under Item 303(a)(4) of Regulation S-K. Contractual Obligations and Commitments The following table summarizes our significant contractual obligations at March 31, 2006, and the effect such obligations are expected to have on our liquidity and cash flows in future periods. This table excludes accounts payable, accrued expenses (except restructuring charges), taxes payable and deferred revenue already recorded on our balance sheet as current liabilities at March 31, 2006.
The above table does not include interest payments of $3.2 million paid every six months on April 1 and October 1 on our 10.0% subordinated notes due April 1, 2008 or interest payments of $9.6 million paid every six months on June 15 and December 15 on our 11.0% senior notes due June 15, 2010.
34
Table of ContentsOther Financing Arrangements Senior Convertible Participating Shares On December 17, 1999, we issued 218,000 6.50% senior convertible participating shares (the “participating shares”) for $218.0 million. The participating shares are entitled to dividends equal to the greater of 6.50% per annum or ordinary share dividends on an as converted basis. In accordance with the terms of their issue, dividends were payable in the form of additional participating shares in the period through to December 2004. The terms of the issue of the senior notes due 2010 forbid the payment of cash dividends. Accordingly, dividends, which are cumulative, were paid in the form of additional participating shares through December 2004. At that time, we were obliged to pay the participating share dividends in cash. However, the terms of the participating shares permit us to continue to pay payment-in-kind dividends following December 17, 2004 if our then existing principal indebtedness, which includes our credit facility and debt securities issued in an aggregate principal amount in excess of $50.0 million in a bona fide underwritten public or private offering, prohibits us from paying cash dividends. Further, if we are not permitted by the terms of the participating shares to pay payment-in-kind dividends following December 17, 2004 and we have insufficient distributable reserves under English law to pay cash dividends, the amount of any unpaid dividend will be added to the “liquidation return” of each participating share. The holders of the participating shares are, in general, entitled to appoint two directors to the board. Since the Company has not paid dividends in cash for six successive quarters following December 2004, they are entitled to appoint a further two directors until the time the Company has paid cash dividends on the participating shares for four successive quarters. As of June 5, 2006, the holders of the participating shares have appointed three directors to the Company’s Board of Directors. The participating shares are currently convertible into ordinary shares at a conversion price of $3.11 per ordinary share (equal to $12.44 per ADS), subject to adjustment in certain circumstances to avoid dilution of the interests of participating shareholders. As of March 31, 2006 the participating shares have voting rights, on an as converted basis, currently corresponding to approximately 29.1% of the total voting power of our capital stock which includes an additional 106,391 participating shares in respect of payment-in-kind dividends. If, by December 17, 2010, we have not converted or otherwise redeemed the participating shares, we are required, subject to compliance with applicable laws and the instruments governing our indebtedness, and except as set out immediately following to redeem all of the then outstanding participating shares. If we fail to do this, we must then redeem the maximum number of such shares that can then lawfully be redeemed, assuming that the liquidation value per participating share is at that time greater than the market value of the ordinary shares into which the participating shares are convertible. The amount to be paid on the redemption of each participating share in cash is the greater of (a) the then liquidation value or (b) the then market value of the ordinary shares into which the participating shares are convertible, in each case plus accumulated and unpaid dividends from the most recent dividend payment date. If the price set out in (b) above is applicable, we are permitted to convert the participating shares into the number of ordinary shares into which they are convertible instead of making the cash payment. English Company law (to which we are subject, as an English corporation) requires that the participating shares may be redeemed only out of our accumulated, realized profits (as described below, and generally described under English law as “distributable profits”) or, subject to some restrictions, the proceeds of a new issuance of shares for the purposes of financing the redemption. We currently estimate that, as of December 17, 2010, the liquidation value of the then outstanding participating shares will be approximately $419.8 million. To the extent that we are legally permitted to do so, and except where a majority of our board of directors decides bona fide that to do so would be materially prejudicial to the business of the subsidiary undertaking, we are required to use our best efforts to ensure that our subsidiary undertakings distribute to us a sufficient amount of their profits, if any, to enable us to redeem the convertible participating shares. If we have insufficient distributable profits on December 17, 2010 to redeem the participating shares in full, we will be required to use our best efforts to complete a fresh issue of shares and use the proceeds of that fresh issue to finance the redemption. As of the date of this document, we have no distributable profits. However, in determining whether we are able to issue new shares, we may take into account then prevailing market conditions and other factors deemed reasonable by a majority of our board of directors, and we will not be required to issue new shares to the extent prohibited by our then existing indebtedness, whether under our principal bank credit facilities or pursuant to debt securities issued in an aggregate principal amount in excess of $50.0 million in a bona fide underwritten public offering or in a bona fide private offering. In the event that we are unable to redeem all of the then outstanding participating shares on December 10, 2010, we are required to redeem so many of the shares as we are able, pro rata among the holders of the participating shares. Any participating shares that are not so redeemed shall remain outstanding, but shall thereafter be entitled to dividends at an increased rate of 8.5% per annum until redemption. In the event of liquidation of Danka, participating shareholders will be entitled to receive a distribution equal to the greater of (a) the liquidation return per share (initially $1,000 and subject to upward adjustment on certain default events by us) plus any accumulated and unpaid dividends accumulating from the most recent dividend date or b) the amount that would have been payable on each participating share if it had been converted into ordinary shares if the market value of those shares exceed the liquidation value of the participating shares.
35
Table of ContentsWe are likely either to pursue alternative financing arrangements or modifications in relation to the relevant requirements in relation both to the redemption of the participating shares and to the maturity of the $175.0 million of senior notes due in June 2010 in order to manage our liquidity and capital requirements beyond those dates. General Electric Capital Corporation We have an agreement with General Electric Capital Corporation (“GECC”) under which GECC agrees to provide financing to our qualified United States customers to purchase equipment. The agreement expires March 31, 2009. In connection with this agreement, we are obligated to provide a minimum level of customer leases to GECC. The minimum level of customer leases is equal to a specified percentage of United States retail equipment and related sales revenues. If we fail to provide a minimum level of customer leases under the agreement, we are obligated to pay penalty payments to GECC. For the fiscal years ended March, 31, 2006 and 2005, the Company was not required to make any penalty payments. For the fiscal year ended March 31, 2004 the Company was obligated for penalty payments of $0.1 million. Tax Payments We have not paid substantial amounts of income tax in the prior three years because of our net operating losses in many jurisdictions due to our net operating losses in those jurisdictions. We are subject to audits by multiple tax authorities with respect to prior years and paid $8.3 million in fiscal year 2006 related to these audits. We expect to pay between $1.6 million and $7.8 million to certain European tax authorities within fiscal year 2007 principally as a result of audits nearing settlements. NEW ACCOUNTING PRONOUNCEMENTS In December 2004, the FASB issued FASB Statement No. 123R, “Share-Based Payment” (“SFAS 123R”), an amendment of FASB Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) SFAS 123R eliminates the ability to account for share-based payments using Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and instead requires companies to recognize compensation expense using a fair-value based method for costs related to share-based payments, including stock options. The expense will be measured as the fair value of the award at its grant date based on the estimated number of awards that are expected to vest, and recorded over the applicable service period. In the absence of an observable market price for a share-based award, the fair value would be based upon a valuation methodology that takes into consideration various factors, including the exercise price of the award, the expected term of the award, the current price of the underlying shares, the expected volatility of the underlying share price, the expected dividends on the underlying shares and the risk-free interest rate. The requirements of SFAS 123R are effective for our fiscal year beginning April 1, 2006. Early adoption of the provisions of SFAS 123R is encouraged, but not required. The Company has elected the modified retrospective method in applying SFAS 123R. At meetings held on January 30 and 31, 2006, our Human Resources Committee of the Board of Directors and our Board of Directors approved the acceleration of the vesting of all of our stock options outstanding as of January 31, 2006. The acceleration of the options took place on March 15, 2006. The purpose of the accelerated vesting was to enable us to avoid recognizing in our income statement compensation expense associated with these options in future periods, due to the adoption of SFAS 123R. The pre-tax charge to be avoided upon adoption of SFAS 123R is expected to be approximately $2.1 million and represents the fair value of the unvested awards as of the date of the acceleration as determined under SFAS 123. As a result of the accelerated vesting, approximately 1.3 million shares with varying remaining vesting schedules became immediately exercisable. In order to help avoid unintended personal benefits to holders of the accelerated options, any shares received through exercise of accelerated options may not be sold by the option holder until the original vesting date of the accelerated option or the termination of the employment of the option holder, whichever occurs first. In connection with the accelerated vesting, each option agreement underlying such options was amended. As a result of the accelerated vesting of the options, we recorded an immaterial charge to earnings under APB 25. We expect the adoption of SFAS 123R will have an unfavorable impact for all future grants on our consolidated results of operations and net income per common share. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current guidelines. This requirement may reduce our net operating cash flows and increase net financing cash flows in periods after adoption. We cannot estimate what those amounts will be in the future because they depend on, among other things, when employees exercise stock options. All grants after March 31, 2006 will be valued using a binomial pricing model and we will recognize the associated expense over the vesting period based on the fair values determined by the binomial pricing model using the accelerated attribution method. ITE M 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The principal market risks (i.e., the risk of loss arising from adverse changes in market rates and prices) to which we are exposed include foreign exchange risk and interest rates on debt.
36
Table of ContentsInterest Rate Risk Our market risk is primarily limited to fluctuations in interest rates as it pertains to our borrowings under our credit facility, while the 11.0% senior notes and the 10.0% subordinated notes bear a fixed rate. We have outstanding $64.5 million of subordinated notes that have a fixed annual interest rate of 10.0% and interest payments of $3.2 million for the subordinated notes will be paid every six months on April 1 and October 1. The subordinated notes mature on April 1, 2008. We have outstanding $175.0 million aggregate principal amount of senior notes that have a fixed annual interest rate of 11.0% and interest payments of $9.6 million for the senior notes will be paid every six months on June 15 and December 15. The senior notes mature on June 15, 2010. We also have a credit facility with Bank of America, which acquired Fleet Capital Corporation, that expires on January 4, 2008, to provide a $50.0 million, senior secured revolving credit facility, which includes a $30.0 million sublimit for standby and documentary letters of credit. The Fleet Credit Facility bears interest at an annual rate equal to, at our option, (a) the sum of the rate of interest publicly announced from time to time by Bank of America as its prime or base rate of interest plus the applicable margin thereon or (b) the sum of LIBOR for interest periods at our option of one, two, three or nine months plus the applicable margin thereon. On December 31, 2003, we entered into a one year letter of credit facility with ABN Amro. On November 2, 2004, this agreement was amended to provide us a letter of credit facility for Euro 11.8 million (U.S. $14.3 million) and an open term credit facility of Euro 1.0 million (U.S. $1.2 million) available for general working capital purposes, including overdrafts. The open term credit facility expired on November 15, 2005. The letter of credit facility expired on December 31, 2005. The facilities were secured by the assets of certain of our Netherlands subsidiaries and were also cash collateralized by Euro 5.0 million (U.S. $6.1 million). On January 1, 2006, we opened a replacement letter of credit facility with ABN Amro in favor of Ricoh in the amount of Euro 11.8 million (U.S. $14.3 million) that is fully cash collateralized and will expire on June 30, 2006. This agreement can be renewed. Foreign Currency Exchange Risk Operating in international markets involves exposure to the possibility of volatile movements in foreign exchange rates. These exposures may impact future earnings and/or cash flows. Revenue from Europe/Australia represented approximately 52.3% and 52.0% of our consolidated revenue during fiscal years 2006 and 2005, respectively. The economic impact of foreign exchange rate movements is complex because such changes are often linked to variability in real growth, inflation, interest rates, governmental actions and other factors. These changes, if material, could cause us to adjust our financing and operating strategies. Therefore, to solely isolate the effect of changes in currency does not accurately portray the effect of these other important economic factors. As foreign exchange rates change, translation of the income statements of our international subsidiaries into United States dollars affects year-over-year comparability of operating results. While we may hedge specific transaction risks, we have not done so and we generally do not hedge translation risks because we believe there is no long-term economic benefit in doing so. At March 31, 2006, we had no outstanding forward contracts or option contracts to buy or sell foreign currency. For the fiscal years 2006, 2005 and 2004 there were no gains or losses included in our consolidated statements of operations on forward contracts and option contracts. Assets and liabilities are matched in the local currency, which reduces the need for United States dollar conversion. Any foreign currency impact on translating assets and liabilities into dollars is included as a component of shareholders’ equity. Our revenue results for fiscal year 2006 were negatively impacted by a $33.1 million foreign currency movement, primarily due to the weakening of the euro and the British pound sterling versus the U.S. dollar. Changes in foreign exchange rates that have the largest impact on translating our international operating profits relate to the euro and the British pound sterling versus the United States dollar. We estimate that a 1% adverse change in foreign exchange rates would have decreased our revenues by approximately $6.0 million in fiscal year 2006, assuming no changes other than the exchange rate itself. As discussed above, this quantitative measure has inherent limitations. Further, the sensitivity analysis disregards the possibility that rates can move in opposite directions and that gains from one currency may or may not be offset by losses from another currency. Seasonality We have experienced some seasonality in our business. Our European operations have historically experienced lower revenue for the second quarter of our fiscal year, which is the three month period ended September 30th. This is primarily due to increased vacation time by European residents during July and August. This has historically resulted in reduced sales activity and reduced usage of photocopiers, facsimiles and other office imaging equipment during that period. Market Risk Our market risk is primarily limited to fluctuations in interest rates as it pertains to our borrowings under our credit facilities while the 11.0% senior notes and the 10% subordinated notes bear a fixed rate.
37
Table of ContentsITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Report of Independent Registered Certified Public Accountants The Board of Directors and Shareholders of Danka Business Systems PLC We have audited the accompanying consolidated balance sheets of Danka Business Systems PLC as of March 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity (deficit), and cash flows for each of the three years in the period ended March 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a)2. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Danka Business Systems PLC at March 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended March 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Danka Business Systems PLC’s internal control over financial reporting as of March 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated June 5, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of internal control over financial reporting, and an adverse opinion on the effectiveness of internal control over financial reporting. /s/ Ernst & Young LLP Tampa, Florida June 5, 2006
38
Table of ContentsConsolidated Statements of Operations for the Years Ended March 31, 2006, 2005 and 2004 (In thousands, except per American Depositary Share (“ADS”) amounts)
The accompanying notes are an integral part of these consolidated financial statements.
39
Table of ContentsConsolidated Balance Sheets as of March 31, 2006 and 2005 (In thousands except share data)
The accompanying notes are an integral part of these consolidated financial statements.
40
Table of ContentsConsolidated Statements of Cash Flows for the Years Ended March 31, 2006, 2005 and 2004 (In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
41
Table of ContentsConsolidated Statements of Shareholders’ Equity (Deficit) For the Years Ended March 31, 2006, 2005 and 2004 (In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
42
Table of ContentsNotes to the Consolidated Financial Statements (all tables in thousands except American Depositary Share (“ADS”) amounts) Note 1. Summary of Significant Accounting Policies Basis of preparation: The consolidated financial statements of Danka Business Systems PLC (also referred to herein as “Danka” or the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles. The principal accounting policies are set forth below. Basis of consolidation: The consolidated financial statements include the Company’s accounts and the accounts of its majority and wholly owned subsidiaries. The Company’s principal operating subsidiaries are located in the United States, Europe and Australia, and are principally engaged in the distribution and service of photocopiers and related office imaging equipment. All inter-company balances and transactions have been eliminated in consolidation. References herein to “we” or “our” refer to Danka Business Systems PLC and consolidated subsidiaries unless the context specifically states otherwise. Use of estimates: The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at year end and the reported amounts of revenues and expenses during the reporting period. Certain significant estimates are disclosed throughout this report. The Company’s actual results could differ from these estimates. Cash and cash equivalents: Cash and cash equivalents consists of cash on hand and all highly liquid investments or deposits with original maturities of three months or less. Restricted cash: The Company had restricted cash of $20.5 million and $15.0 million at March 31, 2006 and 2005, respectively, which is collaterizing the Company’s lines and letters of credit. Allowances for doubtful accounts: The Company provides allowances for doubtful accounts and allowances for billing disputes and inaccuracies on its accounts receivable as follows:
Inventories: Inventories consist of photocopiers, facsimile equipment and other automated office equipment which are stated at the lower of specific cost or market of $37.9 million at March 31, 2006 and $44.4 million at March 31, 2005. The related parts and supplies are valued at the lower of average cost or market of $42.1 million at March 31, 2006 and $46.6 million at March 31, 2005. On an ongoing basis, the Company reviews for estimated obsolete or unmarketable inventories and writes-down its inventories to their estimated net realizable value based upon its forecasts of future demand and market conditions using historical trends and analysis. Equipment on Operating Leases: Equipment on operating leases is stated at cost less accumulated depreciation. Depreciation is provided using the straight-line method over the assets’ estimated economic lives, generally three to five years. Depreciation is record as retail supplies and rental costs. Property and equipment: Property and equipment is stated at cost. Depreciation and amortization is provided using the straight-line method over the assets’ estimated economic lives. Expenditures for additions, major renewals or betterments are capitalized and expenditures for repairs and maintenance are charged to operations as incurred. When property and equipment is retired or otherwise disposed of, the cost and the applicable accumulated depreciation is removed from the respective accounts and the resulting gain or loss is reflected in operations. The Company expenses software costs incurred in preliminary project stages. The Company capitalizes costs incurred in developing or obtaining internal use software. Capitalized software costs are amortized over a period of three to five years. Costs related to software maintenance and training are expensed as incurred.
43
Table of ContentsGoodwill: Under Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), the Company reviews its goodwill balances for impairment in the fourth quarter of its fiscal year or more frequently if impairment indicators arise. Goodwill is tested for impairment by comparing the fair value of each reporting unit with it carrying value. Fair value is determined with the assistance of third party appraisers utilizing a combination of discounted cash flow and market multiple approaches. Long-lived assets: The carrying value of long-lived assets to be held and used, including property and equipment, equipment on operating leases and other intangible assets, is evaluated for recoverability whenever adverse effects or changes in circumstances indicate that the carrying amount may not be recoverable. Impairments are recognized if future undiscounted cash flows and earnings from operations are not expected to be sufficient to recover the long-lived assets. Other intangible assets: Other intangible assets consist of tradenames, customer lists and non-compete agreements. Tradenames have an indefinite life and are not amortized. Customer lists are amortized over their useful lives, generally two to five years, generally on a straight-line basis. Non-compete agreements are amortized over the lives of the agreements, generally three to fifteen years, on a straight-line basis which approximates the effective interest method. Other assets: Other assets include deferred financing costs which are amortized on a straight-line basis to interest expense over the term of the related debt. Income taxes: In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences which give rise to the deferred tax asset become deductible. The Company’s past financial performance is a significant factor which contributes to its inability, pursuant to Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”), to use projections of future taxable income in assessing the realizability of deferred tax assets. Management therefore is limited to considering the scheduled reversal of deferred tax liabilities and tax planning strategies in making this assessment. Considering the relevant data, management concluded that it is not “more likely than not” that the Company will realize the benefits of certain deferred tax assets at March 31, 2006 and 2005. Consequently, the Company has a valuation allowance against net deferred tax assets in most jurisdictions at March 31, 2006 and 2005. Revenue recognition: The Company generally has agreements to provide product maintenance services for the equipment that it sells or leases to customers. The Company follows the guidance in the Emerging Issues Task Force (“EITF”) Issue 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”), as modified for the impact of higher level accounting literature, to allocate revenue received between the two deliverables in the arrangement – the equipment and the product maintenance services. For arrangements in which the product maintenance services meet the definition in the Financial Accounting Standards Board (“FASB”) Technical Bulletin (“TB”) No. 90-1, “Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts” (“TB 90-1”), of a separately priced product maintenance contract, revenue equal to the amount paid by the customer to obtain the product maintenance services is allocated to the separately priced maintenance agreement, with the remainder of the revenue allocated to the equipment (or operating lease payments for use of the equipment). For arrangements in which the product maintenance services does not meet the definition in TB 90-1 of a separately priced product maintenance contract, but the revenue recognized related to the equipment is governed by FASB Statement No. 13, “Accounting for Leases” (“SFAS 13”), revenue is allocated between the equipment (or operating lease payments for use of the equipment) and product maintenance services on a relative fair value basis using our best estimate of fair value of the equipment (or operating lease payments for use of the equipment) and of the product maintenance services. Revenue from wholesale and retail equipment and related sales, including revenue allocated to equipment sales as discussed above, is recognized upon acceptance of delivery by the customer. In the case of equipment sales financed by third party finance/leasing companies, revenue is recognized at the later of acceptance of delivery by the customer or credit acceptance by the finance/leasing company. In addition, for the sale of certain digital equipment that requires a comprehensive setup by the Company before it can be used by a customer, revenue is recognized upon the customer’s written confirmation of delivery and installation. Supply sales to customers are recognized at the time of shipment unless supply sales are included in a service contract, in which case supply sales are recognized upon equipment usage by the customer. The Company sells equipment with embedded software to its customers. The embedded software is not sold separately, is not a significant focus of the marketing effort, and the Company does not provide post contract customer support specific to the software or incur significant costs that are within the scope of FASB Statement No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed” (SFAS 86”). Additionally, the functionality that the software provides is marketed as part of the overall product. The software embedded in the equipment is incidental to the equipment as a whole such that FASB Statement of Position No. 97-2, “Software Revenue Recognition” (“SFAS 97-2”), is not applicable. Revenue from the sales of equipment subject to an operating lease, or of equipment that is leased by or intended to be leased by the purchaser to another party, and sales-type leases is recognized in accordance with SFAS 13. Revenue from all other sales of equipment is recognized in accordance with SEC Staff Accounting Bulletin No. 104.
44
Table of ContentsRental operating lease income is recognized straight-line over the lease term. Retail service revenues are generally recognized ratably over the term of the underlying product maintenance contracts. Under the terms of the product maintenance contract, the customer is billed a flat periodic charge and/or a usage-based fee. The typical agreement includes an allowance for a minimum number of copies for a base service fee plus an overage charge for any copies in excess of the minimum. The Company records revenue each period for the flat periodic charge and for actual or estimated usage. Cost of sales: Inbound freight charges are included in inventory. When the inventory is sold, the cost of the inventory, including the inbound freight charges, is relieved and charged to costs of sales. When the inventory is rented, the cost of the inventory, including the inbound freight charges, is relieved and transferred to the rental equipment asset account. The cost of the rental equipment asset is then depreciated over the estimated useful life of the equipment. The depreciation of rental equipment assets is included in retail supplies and rental costs. Purchasing and receiving costs, inspection costs, warehousing costs and other distribution costs are included in selling, service and administrative costs because no meaningful allocation of these expenses to equipment, supplies, rental and wholesale costs of sales is practicable. Rebates: The Company receives vendor rebates based on arrangements with certain vendors. Those arrangements require vendors to make incentive payments to the Company based on the volume of purchases (dollar amounts, quantity of specific units, etc.) for monthly or quarterly periods. Such rebates are accrued when purchases are made and can be reasonably estimated, recorded as reductions of inventory costs when accrued, and recognized as a reduction to cost of sales when the related inventories are sold. Shipping and handling costs: Shipping and handling charges billed to the Company’s customers are included in the same category as the related sale. The cost of shipping and handling is included in cost of sales. Advertising: Advertising costs are charged to expense as incurred. Net advertising expenses totaled $2.4 million, $3.4 million and $4.4 million for fiscal years 2006, 2005 and 2004, respectively. Restructuring charges: The Company recognizes a liability for costs associated with an exit or disposal activity when the liability is incurred under the provisions of FASB Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). The Company accounts for ongoing benefit arrangements under FASB Statement No. 112, “Employers’ Accounting for Postemployment Benefits,” (“SFAS 112”) which requires that a liability be recognized when the costs are probable and reasonably estimable. Earnings per share: Basic earnings per share (“EPS”) is computed by dividing income available to common shareholders by the weighted average number of shares outstanding for the period. Diluted EPS reflects the potential dilution from the exercise of stock options or the conversion of securities into stock. Earnings (loss) attributable to common shareholders is determined by reducing net earnings or loss by the dividends and accretion for the relevant fiscal year paid on the 6.5% senior convertible participating shares. Earnings per American Depositary Share (“ADS”) are based on the current ratio of four ordinary shares to one ADS. Foreign currencies: The functional currency for most foreign operations is the local currency. Foreign currency transactions are converted at the rate of exchange on the date of the transaction or translated at the year end rate in the case of transactions not then finalized. Gains and losses resulting from foreign currency transactions are included in other expense (income) in the accompanying statements of operations. Assets and liabilities in currencies other than United States dollars are translated into United States dollars at the exchange rate in effect at the balance sheet date. Revenues and expenses are translated using the average rate of exchange for the period. The resulting translation adjustments are recorded as accumulated other comprehensive loss, a separate component of shareholders’ equity (deficit). Concentrations of risk: Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash and cash equivalents, restricted cash, trade receivables, trade payables and long-term debt. The Company’s cash and cash equivalents and restricted cash are placed with high credit quality financial institutions, and are invested in short-term maturity, highly rated securities. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company’s customer base and their dispersion across many different industries and geographical areas. As of March 31, 2006, the Company had no significant concentrations of credit risk. The Company’s business is dependent upon close relationships with its vendors and its ability to purchase photocopiers and related office imaging equipment from these vendors on competitive terms. The Company primarily purchases products from several key vendors including Canon, Ricoh and Toshiba, each of which represented 10% or more of equipment purchases for the years ended March 31, 2006, 2005 and 2004.
45
Table of ContentsConvertible Participating Shares: The Company accretes to the redemption value of its 6.5% convertible participating shares over the period from the date of issuance to the earliest redemption date of the convertible participating shares using the straight-line method that approximates the interest method. The unaccreted amount at March 31, 2006 was $5.5 million. Stock Based Compensation: The Company has employee stock benefit plans, which are described more fully in Note 15—Share Option and Stock Compensation Plans. The Company’s stock option plans are accounted for under the intrinsic value recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations. As the exercise price of all options granted under these plans was equal to the market price of the underlying common stock on the grant date. However, $0.2 million of stock-based employee compensation cost is recognized in net income related to the issuance of shares to the Company’s Board of Directors pursuant to the 2002 outside Director Stock Compensation Plan. In addition, at meetings held on January 30 and 31, 2006, our Human Resources Committee of the Board of Directors and our Board of Directors approved the acceleration of the vesting of all of our stock options outstanding as of January 31, 2006. The acceleration of the options took place on March 15, 2006. The purpose of the accelerated vesting is to enable us to avoid recognizing in our income statement compensation expense associated with these options in future periods, due to the adoption of FASB Statement No. 123R, “Share-Based Payment” (“SFAS 123R”). The pre-tax charge to be avoided upon adoption of SFAS 123R is expected to be approximately $2.1 million and represents the fair value of the unvested awards as of the date of the acceleration as determined under FASB Statement No. 123, “Accounting for Stock-Based Compensation.” (“SFAS No. 123”). As a result of the accelerated vesting, approximately 1.3 million shares with varying remaining vesting schedules became immediately exercisable. In order to help avoid unintended personal benefits to holders of the accelerated options, any shares received through exercise of accelerated options may not be sold by the option holder until the original vesting date of the accelerated option or the termination of the employment of the option holder, whichever occurs first. In connection with the accelerated vesting, each option agreement underlying such options was amended. As a result of the accelerated vesting of the options, we recorded an immaterial charge to earnings under APB 25. The following table illustrates the effect on net earnings (loss) available to common shareholders and earnings (loss) available to common shareholders per ADS if we had applied the fair value recognition provisions of SFAS 123, to employee stock benefits, including shares issued under the stock option plans. For purposes of this pro-forma disclosure, the estimated fair value of the options using the Black-Sholes method for the fiscal years ending March 31, 2006, 2005 and 2004 would have been as follows:
See Note 15 – Share Option and Stock Compensation for a discussion of the assumptions used in the option pricing model and estimated fair value of employee stock options. Pensions: The Company accounts for its defined benefit pension plans using FASB Statement No. 87, “Employer’s Accounting for Pensions” (“SFAS 87”), and the disclosure rules under FASB Statement No. 132 revised, “Employers Disclosures about Pensions and Other Postretirement Benefits” (“SFAS 132”). Under SFAS 87, pension expense is recognized on an accrual basis over employees’
46
Table of Contentsapproximate service periods. Pension expense calculated under SFAS 87 is generally independent of funding decisions or requirements. The calculation of pension expense and the Company’s pension liability requires the use of a number of assumptions. Changes in these assumptions can result in different expense and liability amounts, and future actual experience can differ from the assumptions. The Company believes that the two most critical assumptions are the expected long-term rate of return on plan assets and the assumed discount rate. Future changes in plan asset returns, assumed discount rates and various other factors related to the participants in the Company’s pension plans will impact its future pension expense and liabilities. The Company cannot predict with certainty what these factors will be in the future. Accumulated other comprehensive loss: At March 31, 2006, accumulated other comprehensive loss consisted of $30.0 million and $16.1 million of currency translation adjustment and minimum pension liability, respectively. At March 31, 2005, accumulated other comprehensive loss consisted of $43.8 million and $11.4 million of currency translation adjustment and minimum pension liability, respectively. New Accounting Pronouncements: In December 2004, the FASB issued SFAS 123R, an amendment of SFAS 123. SFAS 123R eliminates the ability to account for share-based payments using APB 25 and instead requires companies to recognize compensation expense using a fair-value based method for costs related to share-based payments, including stock options. The expense will be measured as the fair value of the award at its grant date based on the estimated number of awards that are expected to vest, and recorded over the applicable service period. In the absence of an observable market price for a share-based award, the fair value would be based upon a valuation methodology that takes into consideration various factors, including the exercise price of the award, the expected term of the award, the current price of the underlying shares, the expected volatility of the underlying share price, the expected dividends on the underlying shares and the risk-free interest rate. The requirements of SFAS 123R are effective for our fiscal year beginning April 1, 2006. Early adoption of the provisions of SFAS 123R is encouraged, but not required. The Company has elected the modified retrospective method in applying SFAS 123R. At meetings held on January 30 and 31, 2006, our Human Resources Committee of the Board of Directors and our Board of Directors approved the acceleration of the vesting of all of our stock options outstanding as of January 31, 2006. The acceleration of the options took place on March 15, 2006. The purpose of the accelerated vesting is to enable us to avoid recognizing in our income statement compensation expense associated with these options in future periods, due to the adoption of SFAS 123R. The pre-tax charge to be avoided upon adoption of SFAS 123R is expected to be approximately $2.1 million and represents the fair value of the unvested awards as of the date of the acceleration as determined under SFAS 123. As a result of the accelerated vesting, approximately 1.3 million shares with varying remaining vesting schedules became immediately exercisable. In order to help avoid unintended personal benefits to holders of the accelerated options, any shares received through exercise of accelerated options may not be sold by the option holder until the original vesting date of the accelerated option or the termination of the employment of the option holder, whichever occurs first. In connection with the accelerated vesting, each option agreement underlying such options was amended. As a result of the accelerated vesting of the options, we recorded an immaterial charge to earnings under APB 25. The Company expects the adoption of SFAS 123R will have an unfavorable impact for all future grants on its consolidated results of operations and net income per common share. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current guidelines. This requirement may reduce the Company’s net operating cash flows and increase net financing cash flows in periods after adoption. The Company cannot estimate what those amounts will be in the future because they depend on, among other things, when employees exercise stock options. All grants after March 31, 2006 will be valued using a binomial pricing model and we will recognize the associated expense over the vesting period based on the fair values determined by the binomial pricing model using the accelerated attribution method. United Kingdom Companies Act 1985: The financial statements for the years ended March 31, 2006, 2005, and 2004 do not comprise statutory accounts within the meaning of Section 240 of the United Kingdom Companies Act 1985. Statutory accounts prepared under United Kingdom generally accepted accounting principles for the year ended March 31, 2006 will be delivered to the Registrar of Companies for England and Wales following our 2006 annual general meeting. The auditors’ reports on those statutory accounts is expected to be unqualified. Reclassifications: Certain prior year amounts have been reclassified to conform to current year presentations. Note 2. Goodwill and Other Intangible Assets Goodwill was reviewed for possible impairment as of January 1, 2006 and 2005, in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”. In performing its impairment testing, the Company engaged an independent company to assist in the valuation of its reporting units. The fair value of the reporting units was determined using a combination of a discounted cash flow model and a guideline company method using market multiples. The discounted cash flow model used estimates of future revenue and
47
Table of Contentsexpenses for each reporting unit as well as appropriate discount rates, and the estimates that were used are consistent with the plans and estimates the Company is using to manage the underlying business. Based on the analysis as of January 1, 2005, management determined that the goodwill balance was impaired for its Europe/Australia reporting unit. As such, additional goodwill impairment testing was completed for that reporting unit, and based on those results, the Company recorded an impairment charge totaling $70.9 million during fiscal year 2005. No such charge was needed in fiscal year 2006. As of March 31, 2006, goodwill was $206.2 million. Changes to goodwill for the fiscal year ended March 31, 2006 resulted primarily from fluctuations in foreign currency exchange rates. In addition, the Company wrote off $2.9 million of goodwill upon the sale of its Canadian subsidiary. Goodwill by reporting units as of March 31, 2006 and 2005 was as follows:
Other intangible assets, principally customer lists, was $1.9 million, net of $3.3 million of accumulated amortization. Aggregate amortization expense of other intangible assets for fiscal years 2006, 2005 and 2004 was $1.3 million, $0.5 million and $0.4 million, respectively. Estimated amortization expense for fiscal year 2007 is $0.6 million and the succeeding four fiscal years is between $0.1 million and $0.7 million per year. Note 3. Restructuring Charges Fiscal Year 2005 Plan: In fiscal year 2005, the Company formulated plans to continue to eliminate inefficiencies in its field operations and to reduce its selling, general and administrative costs by eliminating and consolidating back office functions and exiting certain facilities. These charges were accounted for under the provisions of SFAS 112 and SFAS 146. As part of these plans, the Company recorded a $15.2 million restructuring charge in fiscal year 2006 primarily relating to severance charges due to additional cost reduction efforts. These charges were offset by a reduction in severance charges of $3.3 million due to favorable severance negotiations and employee attrition. Cash outlays for severance and facilities during the year were $10.4 million and $0.4 million, respectively. The other non-cash changes of $0.7 million represent foreign currency adjustments. The remaining liability of the 2005 Plan restructuring charge of $6.1 million and $4.6 million is categorized within “Accrued expenses and other current liabilities” and “Deferred income taxes and other long-term liabilities”, respectively. The following table summarizes the fiscal year 2005 Plan restructuring charge: 2005 Plan Restructuring Charge:
2005 Plan Restructuring Severance Charge by Operating Segment:
48
Table of Contents2005 Plan Restructuring Facility Charge by Operating Segment:
Fiscal Year 2004 Plan: In fiscal year 2004, the Company formulated plans to significantly reduce its selling, general and administrative costs by consolidating the back-office functions in the United States, exiting non-strategic real estate facilities and reducing headcount in the United States and Europe/Australia. These charges were accounted for under the provisions of SFAS 112 and SFAS 146. As part of these plans, the Company recorded a $47.3 million restructuring charge in fiscal year 2004 that included $24.1 million related to severance for employees and $23.2 million related to future lease obligations for facilities that were vacated by March 31, 2004. The fiscal year 2004 restructuring charge was partially offset by $0.6 million reversal of prior years’ restructuring charges. The Company reversed $2.0 million of fiscal year 2004 Plan severance and facility charges during fiscal year 2005 as a result of employee attrition in its United States and Europe/Australia segments, and a change in restructuring plans in Europe/Australia due to improved performance in certain markets partially offset by a higher estimate of facility charges in the United States due to its inability to sublease the facilities. Cash outlays for employee severance during fiscal year 2006 were $2.2 million. In addition, the Company reversed $0.3 million of severance costs during the period due to employee attrition. The remaining non-cash change of $0.1 million represents foreign currency adjustments. Cash outlays for facilities for fiscal year 2006 were $7.1 million. The Company incurred $0.9 million of fiscal year 2004 Plan facility charges during fiscal year 2006, as a result of broker commissions paid in the United States due to the sub-lease of certain facilities. If remaining leases are not terminated, payments will continue through their respective terms. The remaining liability of the 2004 Plan restructuring charge of $4.0 million and $2.6 million is categorized within “Accrued expenses and other current liabilities” and “Deferred income taxes and other long-term liabilities”, respectively. The following table summarizes the fiscal year 2004 Plan restructuring charge: 2004 Plan Restructuring Charge:
49
Table of Contents2004 Plan Restructuring Severance Charge by Operating Segment:
2004 Plan Restructuring Facility Charge by Operating Segment:
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||