Source Interlink Companies 10-K 2007
WASHINGTON, D.C. 20549
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended January 31, 2007
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 001-13437
[SOURCE INTERLINK COMPANIES LOGO]
SOURCE INTERLINK COMPANIES, INC.
(Exact name of registrant as specified in its charter)
(Registrants telephone number, including area code)
Securities registered pursuant to section 12(b) of the Act:
COMMON STOCK $0.01 PAR VALUE
Securities registered pursuant to section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
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.
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants 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. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of July 31, 2006 was approximately $374.6 million computed by reference to the price at which the common equity was sold on July 31, 2006, the last day of the registrants most recently completed second fiscal quarter, as reported by The Nasdaq National Market.
At April 9, 2007 the Company had 52,183,852 shares of common stock $0.01 par value outstanding.
Portions of the Registrants definitive Proxy Statement for the 2007 Annual Meeting of Stockholders are incorporated by reference in Part III of this Form 10-K.
Some of the information contained in this Annual Report on Form 10-K including, but not limited to, those contained in Item 1. Business and Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations, along with statements in other reports filed with the Securities and Exchange Commission (the SEC), external documents and oral presentations, which are not historical facts are considered to be forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The words believe, expect, anticipate, estimate, project, and similar expressions often characterize forward-looking statements. These statements may include, but are not limited to, projections of collections, revenues, income or loss, cash flow, estimates of capital expenditures, plans for future operations, products or services, and financing needs or plans, as well as assumptions relating to these matters. These statements are only predictions and you should not unduly rely on them. Our actual results will differ, perhaps materially, from those anticipated in these forward-looking statements as a result of a number of factors, including the risks and uncertainties faced by us described below and those set forth below under Item 1A. Risk Factors:
· market acceptance of and continuing demand for physical copies of magazines, DVDs, CDs and other home entertainment products;
· the impact of competitive products and technologies;
· the pricing and payment policies of magazine publishers, film studios, record labels and other key vendors;
· changing market conditions and opportunities;
· our ability to realize operating efficiencies, cost savings and other benefits from recent acquisitions; and
· retention of key management and employees.
We believe it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to predict accurately or over which we have no control. The factors listed above provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. Before you make an investment decision relating to our common stock, you should be aware that the occurrence of the events described in these risk factors and those set forth below under Item 1A. Risk Factors could have a material adverse effect on our business, operating results and financial condition. You should read and interpret any forward-looking statement in conjunction with our consolidated financial statements, the notes to our consolidated financial statements and Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operation. Any forward-looking statement speaks only as of the date on which that statement is made. Unless required by U.S. federal securities laws, we will not update any forward-looking statement to reflect events or circumstances that occur after the date on which the statement is made.
We are a premier marketing, merchandising and fulfillment company of entertainment products including DVDs, music CDs, magazines, books and related items serving abhout 110,000 retail store locations throughout North America. Our fully integrated businesses include:
· Distribution and fulfillment of entertainment products to major retail chains throughout North America and direct-to-consumers via the Internet;
· Import and export of periodicals sold in more than 100 markets worldwide;
· Coordination of product selection and placement for impulse items sold at checkout counters;
· Processing and collection of rebate claims as well as management of sales data obtained at the point-of-purchase;
· Design, manufacture and installation of wire fixtures and custom wood displays in major retail chains.
Our clients include:
· Mainstream retailers, such as Wal-Mart Stores, Inc., The Kroger Company, Target Corporation, Walgreen Company, Ahold USA, Inc., Sears Holdings Corporation, and Meijer;
· Specialty retailers, such as Barnes & Noble, Inc., Borders Group, Inc., Hastings Entertainment, Inc., Frys Electronics, Inc. and Circuit City Stores, Inc.; and
· e-commerce retailers, such as amazon.com, barnesandnoble.com, circuitcity.com and bestbuy.com.
Our suppliers include:
· Record labels, such as Vivendi Universal S.A., Sony BMG Music Entertainment Company, WEA Distribution and Thorn-EMI;
· Film studios, such as The Walt Disney Company, Time-Warner Inc., Sony Corp., The News Corporation, Paramount Home Entertainment, Inc., Viacom Inc. and General Electric Company; and
· Magazine Distributors, such as COMAG Marketing Group, LLC., Time Warner Retail Sales & Marketing, Inc., Curtis Circulation Company and Kable Distribution Services, Inc.
On February 28, 2005, we completed the acquisition of Alliance Entertainment Corp, a logistics and supply chain management services company for the home entertainment product market pursuant to the terms and conditions of the Agreement and Plan of Merger Agreement dated as of November 18, 2004 (the Merger Agreement).
We consummated the merger with Alliance to further our objective of creating the premier provider of information, supply chain management and logistics services to retailers and producers of home entertainment content products. We believe that the merger has provided significant market opportunities to take advantage of our strong retailer relationships and experience in marketing our products by expanding product offerings beyond our existing magazine fulfillment business to DVDs, CDs, video games and related home entertainment products and accessories. In addition, we believe that our in-store merchandising capabilities have been strengthened. We also believe this transaction has positioned us as the distribution channel of choice for film studios, record labels, publishers and other producers of home entertainment content products. We have benefited from substantial cost savings in the areas of
procurement, marketing, information technology and administration and from other operational efficiencies, particularly in the distribution and fulfillment functions, where we have consolidated some distribution operations, reorganized others and leveraged our best practices across all of our distribution operations. As a result, we believe the merger has enhanced our financial strength, increased our visibility in the investor community and strengthened our ability to pursue further strategic acquisitions.
The total purchase price of approximately $315.5 million consisted of $304.7 million in Source Interlink common stock, representing approximately 26.9 million shares, $6.5 million related to the exchange of approximately 0.9 million shares of common stock on exercise of outstanding stock options, warrants and other rights to acquire Alliance common stock and direct transaction costs of $4.3 million. The value of the common stock was determined based on the average market price of Source Interlink common stock over the 5-day period prior to and after the announcement of the merger in November 2004. The value of the stock options was determined using the Black-Scholes option valuation model. Following the merger, we organized the combined company into three operating segments:
· Magazine FulfillmentThe magazine fulfillment segment sells and distributes magazines and books to major retailers and wholesalers, imports foreign titles for domestic retailers and wholesalers, exports domestic titles to foreign wholesalers, provides return processing services, serves as an outsource fulfillment agent and provides customer-direct fulfillment.
· CD and DVD FulfillmentThe CD and DVD fulfillment segment sells and distributes pre-recorded music, videos, video games and related products to retailers, provides product and commerce solutions to retailers and provides customer-direct fulfillment and vendor managed inventory.
· In-Store ServicesThe in-store services segment designs, manufactures, ships, installs, removes and invoices participants in front-end wire fixture and custom wood display programs, provides claim filing services for rebates owed retailers from publishers and their agents and provides information and management services relating to retail magazine sales to U.S. and Canadian retailers and magazine publishers.
This segment structure represents a change in structure from that reported in Item 1. Business in our Form 10-K for the fiscal year ended January 31, 2005. The segment organization presented herein corresponds to the financial and other reporting received by our chief operating decision maker. For financial and geographic information regarding our segments see Note 17 Segment Information to our Consolidated Financial Statements.
Following our acquisition of Alliance, we performed the following three acquisitions that have strengthened our position in the mainstream magazine distribution business:
· On May 10, 2005, we entered into a Unit Purchase Agreement with Chas. Levy Company, LLC. Under the terms of the agreement, we purchased all of the issued and outstanding membership interests in Chas. Levy Circulating Co. LLC (Levy) from Seller for a purchase price of approximately $30 million, subject to adjustment based on Levys net worth as of the closing date of the transaction. In addition, approximately $19.3 million was also provided on the date of acquisition to repay all outstanding intercompany debt of Levy. The purchase price and the intercompany debt repayment were funded from the revolving line of credit.
· On March 30, 2006, we entered into a Unit Purchase Agreement, under which we purchased all of the issued and outstanding membership interests of Anderson Mid-Atlantic News, LLC (Mid-Atlantic) from Anderson News, LLC for a purchase price of approximately $4.0 million, subject to adjustment based on the negative net worth as of the closing date of the transaction. In addition, approximately $9.6 million was also provided on the date of acquisition to Mid-Atlantic to repay a portion of their outstanding intercompany debt. The remaining outstanding intercompany debt of
Mid-Atlantic was satisfied by issuance of a promissory note totaling $4.1 million. The promissory note was repaid by the Company during the fiscal year ended January 31, 2007. The purchase price and the intercompany debt repayment were funded by borrowings against our revolving line of credit.
· On March 30, 2006, we entered into a Unit Purchase Agreement, under which we purchased all of the issued and outstanding membership interests of Anderson-SCN Services, LLC (SCN) from Anderson News, LLC for a purchase price of approximately $9.0 million, subject to adjustment based on the negative net worth as of the closing date of the transaction. In addition, approximately $17.0 million was also provided on the date of acquisition to SCN to repay a portion of their outstanding intercompany debt. The remaining outstanding intercompany debt of SCN was satisfied by issuance of a promissory note totaling $10.2 million. The promissory note was repaid by the Company during the fiscal year ended January 31, 2007. The purchase price and the intercompany debt repayment were funded by borrowings against our revolving line of credit.
Also during the fourth quarter of Fiscal 2007, the Company recorded a goodwill and intangible assets impairment of $32.7 million. See Item 7Managements Discussion and Analysis of Financial Condition and Results of Operations.
Our Board of Directors, in consultation with its strategic advisor, The Yucaipa Companies, LLC, hired Deutsche Bank Securities Inc. to act as its exclusive financial advisor in its process of evaluating strategic alternatives to enhance stockholder value, including but not limited to, a recapitalization, strategic acquisitions, and the combination, sale or merger of the Company with another entity.
In connection with this evaluation process, Deutsche Bank Securities, Inc. has worked with an affiliate of The Yucaipa Companies, LLC, the Companys consultant with respect to analyzing strategic alternatives. There can be no assurance that the exploration of strategic alternatives will result in a transaction. We do not intend to disclose developments with respect to the exploration of strategic alternatives unless and until our Board of Directors has approved a specific course of action.
The Yucaipa Companies, LLC is an affiliate of AEC Associates, LLC, our largest shareholder.
Copies of our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports are available, as soon as practicable after filing with the SEC, free of charge on our website, www.sourceinterlink.com. Our Code of Business Conduct and Ethics is also available on our website, together with the charters for the Audit Committee, Compensation Committee, Nominating and Corporate Governance Committee and Capital Markets Committee of our Board of Directors. Written requests for copies of these documents may be directed to Investor Relations at our principal executive offices.
Also, on February 28, 2005, we reincorporated our company from Missouri into Delaware (the Reincorporation). The Reincorporation was adopted and approved at a special meeting of our shareholders. Each stock certificate representing our issued and outstanding shares prior to the Reincorporation will continue to represent the same number of our shares after the Reincorporation. The Reincorporation did not result in any change in our name, headquarters, business, jobs, management, location of offices or facilities, number of employees, assets, liabilities or net worth. Our common stock continues to be traded on the Nasdaq National Market under the symbol SORC.
As a result of the Reincorporation, the rights of our stockholders became subject to and are now governed by Delaware law, a new certificate of incorporation and new bylaws. Certain differences in the rights of stockholders arise from distinctions between Missouri law and Delaware law, as well as from differences between the charter instruments of our Company. These differences are described in the section entitled Comparison of Stockholder Rights and Corporate Governance Matters on pages 149-165 of the Registrants Registration Statement on Form S-4/A filed on January 18, 2005, which section is incorporated herein by reference.
According to industry sources, including the Motion Picture Association, the Recording Industry Association of America, Harrington Associates, LLC, and the American Booksellers Association, the total retail market in calendar year 2006 for DVDs, prerecorded music, single-copy magazines and books was approximately $59.4 billion.
The structure of the distribution channel for single-copy magazines is that publishers each generally engage a single national distributor, which acts as its representative to regional and local wholesalers and furnishes billing, collecting and marketing services throughout the United States or other territories. These national distributors then secure distribution to retailers typically through a number of regional and local wholesalers. The wholesalers maintain direct vendor relationships with the retailers. Retailers in the mainstream retail market, which consists primarily of grocery stores, drug stores and mass merchandise retailers require these wholesalers to provide extensive in-store services including, for traditional trading terms accounts, receiving and verifying shipments, and for scan-based and traditional trading terms accounts, stocking new issues and removing out-of-date issues. However, this structure is not economically viable in the specialty retail market, which consists of bookstore chains, music stores and other specialty retailers. Thus, wholesalers servicing the specialty retail market typically do not provide these in-store services.
In contrast, the distribution channel for prerecorded video and music products is dominated by the major film studios and record labels, which through their respective distribution units periodically compete with intermediaries by seeking to establish direct trading relationships with high volume retailers. This disintermediation strategy has limited appeal to retailers that demand a variety of value-added services, including e-commerce support, inventory management, return logistics, advertising and marketing assistance, information services, and in store merchandising services to manage these increasingly volatile categories. Some retailers have sought to maintain a dual supply chain by establishing a direct trading relationship with the major studios and labels for high volume product, primarily newly released titles, and a more expansive procurement and service relationship with intermediaries to secure lower volume, higher margin product and value-added services.
The retail sale of single-copy magazines is largely an impulse purchase decision by the consumer, and the retail sale of other home entertainment content is becoming increasingly so. As a result, film studios, record labels, publishers and manufacturers of other impulse merchandise such as confections and general merchandise (i.e., razor blades, film, batteries, etc.) consider it important for their products to be on prominent display in those areas of a store where they will be seen by the largest number of shoppers in order to increase the likelihood that their products will be sold. Retailers typically display DVDs, CDs, magazines, confections and general merchandise in specific aisles, or the mainline, and the checkout
area, or the front-end. Product visibility is highest in the front-end because every shopper making a purchase must pass through this area.
Due to the higher visibility and resulting perception of increased sales potential, vendors compete vigorously for favorable display space in the front-end. To secure the desired display space, vendors offer rebate and other incentive payments to retailers, such as:
· initial fees to rearrange front-end display fixtures to ensure the desired placement of their products;
· periodic placement fees based on the location and size of their products display; and
· cash rebates based on the total sales volume of their products.
Due to the high volume of sales transactions and great variety of incentive programs offered, there is a significant administrative burden associated with front-end management. As a result, most retailers have historically outsourced the information gathering and administration of rebate claims collection to third parties such as our company. This relieves retailers of the administrative burdens, such as monitoring thousands of titles each with a distinct incentive arrangement.
Prompt delivery of information regarding sales activity, including timing of the redesign of front-end space, changes in display positions or the discontinuance of a vendors product, is important to vendors of front-end products. This information allows vendors to make important strategic decisions in advance of re-configurations and other changes implemented by retailers to the front-end. Conversely, timely delivery of information about price changes, special promotions, new product introductions and other plans is important to retailers because it enables them to enhance the revenue potential of the front-end. Historically, information available to vendors regarding retail activity at the front-end and information available to retailers about vendors has been fragmented and out-of-date. We believe that there is an increasing demand on the part of vendors of front-end products for more frequent and detailed information regarding front-end retail activity. Through our operating units we have access to a significant amount of information regarding retail front-end and mainline sales activity.
Our business consists of three operating segments, as discussed above. Due to the similar operating characteristics of the Magazine Fulfillment and CD and DVD Fulfillment, they are discussed in aggregate, as the Fulfillment business unit below.
In the spring of 2001, we acquired a group of affiliated specialty magazine distributors to establish a platform from which to offer an expanding list of merchandise and services to retailers. From 2002 through 2004, we continued to expand our magazine product offerings by licensing and then purchasing international distribution rights to a series of domestic magazine titles. In February 2005, we further expanded our product offering beyond magazine fulfillment to include DVDs, CDs and other home entertainment content products through our merger with Alliance. In May 2005, we acquired Chas. Levy Circulating Co., one of the principal magazine wholesalers in the United States, for the purpose of strengthening our position in the mainstream retail market. In March 2006, we acquired Anderson Mid-Atlantic News, LLC and Anderson-SCN Services, LLC, major distributors of magazines in the mid-Atlantic and Southern California regions, respectively. For a more complete discussion of the Alliance merger, the acquisition of Chas. Levy Circulating Co., and the acquisitions of Anderson Mid-Atlantic News, LLC and Anderson-SCN Services, LLC, see Recent Developments.
Currently, our Fulfillment unit offers a broad array of products and services including the following:
Through our extensive relationships with record labels, film studios, magazine publishers and other producers of home entertainment content, we can offer our retail clients the ability to display virtually every domestic DVD, CD and magazine title and a significant selection of foreign titled magazines. To maintain the high order fill rate demanded by our clients, we have established an in stock catalogue of approximately 300,000 CD titles and approximately 100,000 DVD titles. We purchase home entertainment content from every major record label, film studio and magazine publisher, typically on a fully returnable basis.
Product is received at strategically located distribution centers. The principal distribution centers are located in Harrisburg, Pennsylvania, Coral Springs, Florida, Shepherdsville, Kentucky, Dallas, Texas, Lancaster, Pennsylvania, Ontario, California, Chicago, Illinois, and Brainerd, Minnesota. At each of these distribution points, we process merchandise orders using sophisticated warehouse management systems. Once filled, orders are shipped to our retailers by a combination of third party freight carriers and, in certain high volume locations, in-house truck delivery. Given our broad distribution infrastructure, we are capable of delivering home entertainment content overnight to virtually any location within the continental United States.
Our sophisticated warehouse management systems, just-in-time replenishment and order regulation techniques enable us to offer value-added fulfillment services including next day order delivery, ready for shelf inventory preparation (such as price labeling and security device placement) and a wide variety of electronic data interchange tools.
Most customers utilizing our fulfillment services are brick and mortar retailers some of which seek support for their e-commerce initiatives in the DVD and CD markets. For these clients, which include barnesandnoble.com, amazon.com and bestbuy.com, we offer a comprehensive e-commerce platform, which includes direct customer product delivery, real-time inventory querying and commitment capabilities, credit card processing and settlement services, custom packaging, promotional inserts and customer care services. Other fulfillment services clients furnish magazines to us, rather than purchasing the product from us, which we then package into individual orders and ship directly to individual retail outlets.
For retailers seeking a total merchandising solution, we offer category management services that include product selection and preparation, fixturing, in-store stocking and replenishment, marketing and promotional program development, and inventory control.
The In-Store Services group provides rebate and other incentive payment collection, information services and display fixture design and manufacture.
Claim submission services related to the display and sale of magazines have been the historical core of our business. U.S. and Canadian retailers engage our In-Store Services group to accurately monitor, document, claim and collect publisher rebate and other incentive payments. Our services are designed to
relieve our clients of the substantial administrative burden associated with documenting, verifying and collecting their payment claims, and to collect a larger percentage of the potential incentive payments available to the retailers.
We established our Advance Pay Program as an enhancement to our claim submission services. Typically, retailers are required to wait a significant period of time to receive payments on their claims for incentive rebates. We improve the retailers cash flow by advancing the claims for rebates and other incentive payments filed by us on their behalf, less our commission, within a contractually agreed upon period after the end of each quarter.
In connection with our claim submission services, we gather extensive information on magazine sales, pricing, new titles, discontinued titles and display configurations on a chain-by-chain and store-by-store basis. As a result, we are able to furnish our clients with reports of total sales, sales by class of trade and sales by retailer, as well as reports of unsold magazines and total sales ranking. One of our products, the Cover Analyzer, permits subscribers to determine the effectiveness of particular magazine covers on sales for 300 top selling titles in the United States. Our website gives subscribers the capability to react more quickly to market changes, including the ability to reorder copies of specific issues, track pricing information, introduce new titles, and act on promotions offered by publishers. Publishers also use the website to promote special incentives and advertise and display special editions, new publications and upcoming covers. We have supplemented our own data with data obtained under agreements with Barnes & Noble, Inc., Walgreen Company and The Kroger Company.
To enhance retailers marketing efficiency, we developed the capacity to design, manufacture, deliver and dispose of custom front-end and point-of-purchase displays for both retail store chains and product manufacturers. Retailers perceive our experience in developing and implementing product display strategies supported by our information services as helpful in improving the revenue they generated from the sale of home entertainment content merchandise. In addition, we believe that our influence on the design and manufacture of display fixtures enhances our ability to incorporate features that facilitate the gathering of information. Our services in this regard frequently include designing front-end display fixtures, supervising fixture installation, selecting products and negotiating, billing and collecting incentive payments from vendors. We frequently assist our retailer clients in the development of specialized marketing and promotional programs, which include special mainline or front-end displays and cross-promotions of magazines and products of interest to the readers of these magazines. Raw materials used in manufacturing our fixtures include wire, wood, powder coating, paints and stains, metal tubing and paneling, wood veneer and laminates, all of which are readily available from multiple sources.
We manufacture custom wood store fixtures and displays to customer specifications using wood veneers and laminates. Delivery of fixtures is highly concentrated in our second and third fiscal quarters as a result of the demands of retailers to be ready for the critical holiday selling season. To assure that their seasonal demands for the delivery are met, retailers typically provide commitments well in advance of anticipated product delivery. Accordingly, our inventory levels increase during seasonal periods when retailers are not opening or remodeling stores, typically November through April.
Our customers in the specialty retail market consist of bookstore chains, music stores and other specialty retailers. Our customers in the mainstream retail market consist primarily of grocery stores, drug stores and mass merchandise retailers. Two customers account for a large percentage of our total revenues. Barnes & Noble, Inc. accounted for 19.6%, 27.5% and 28.7% in the fiscal years ended January 31, 2007, 2006 and 2005 respectively. Borders Group, Inc. accounted for 5.8%, 6.3% and 24.5% of total revenues in the fiscal years ended January 31, 2007, 2006 and 2005, respectively. Revenues provided by Barnes & Noble, Inc. and Borders Group for the fiscal year ended January 31, 2006 include revenues generated by Alliance from the date of acquisition.
Our target market includes magazine publishers, film studios, record labels, magazine distributors and retailers. We specialize in providing nationwide home entertainment product distribution to retailers with a national or regional scope. We believe that our distribution centers differentiate us from our national competitors and are a key element in our marketing program. Our distribution centers focus on our just-in-time replenishment and our ability to deliver product, particularly magazines published on a weekly basis, overnight to virtually any location within the United States and Puerto Rico.
While we frequently attend trade shows and advertise in trade publications, we emphasize personal interaction between our sales force and customers so that our customers are encouraged to rely on our dependability and responsiveness. To enhance the frequency of contact between our sales force and our customers, we have organized our direct sales force into a unified marketing group responsible for soliciting sales of all products and services available from each of our operating groups. We believe this combined marketing approach will enhance cross-selling opportunities and lower the cost of customer acquisition.
Our CD and DVD Fulfillment segment is highly seasonal. The fiscal fourth quarter is typically the largest revenue producing quarter due to increased distribution of pre-recorded music, videos, and video games during the holiday shopping season.
Our Magazine Fulfillment segment is generally not impacted by a significant amount of seasonality. The fiscal third quarter is typically the largest revenue quarter due to increased distribution of certain monthly titles, such as fashion titles and sports titles, and various quarterly, semi-annual and annual titles that are only produced and distributed in the third quarter to be in retail stores during the holiday shopping season.
Our In-Store Services segment is also highly seasonal. Historically, the largest revenue producing fiscal quarter for this segment is the third. This is primarily due to the fact that most retailers for which we design, manufacture and deliver product want their goods in their retail stores prior to the holiday shopping season, which is our fourth quarter.
The moderate rate of inflation over the past three years has not had a significant effect on our revenues or profitability.
Each of our business units faces significant competition. Our Fulfillment group distributes home entertainment product in competition with a number of national and regional companies, including Anderson News LLC, Anderson Merchandisers, L.P., Hudson News Company, The News Group, Ingram Book Group, Inc., Ingram Entertainment, Inc., Handleman Company, and Baker & Taylor, Inc. Major
record labels and film studios compete with us by establishing direct trading relationships with the larger retail chains.
Our In-Store Services group has a very limited number of direct competitors for its claims submission program, and it competes in a highly fragmented industry with other manufacturers for wood and wire display fixture business. In addition, some of this groups information and management services may be performed directly by publishers and other vendors, retailers or distributors. Other information service providers, including A.C. Nielsen Company, Information Resources and Audit Bureau of Circulations, also collect sales data from retail stores. If these service providers were to compete with us, given their expertise in collecting information and their industry reputations, they could be formidable competitors. In addition, some of this groups information and management services may be performed directly by publishers and other vendors, retailers or distributors.
The principal competitive factors faced by each of our business units are price, financial stability, breadth of products and services, and reputation.
The efficiency of our business units are supported by our information systems that combine traditional outbound product counts with real-time register activity. Our ability to access real-time register data enables us to quickly adjust individual store merchandise allocations in response to variation in consumer demand. This increases the probability that any particular merchandise allotment will be sold rather than returned for credit. In addition, we have developed sophisticated database management systems designed to track various on-sale and off-sale dates for the numerous issues and regional versions of the magazine titles that we distribute.
Our primary operating systems are built on an open architecture platform and provide the high level of scalability and performance required to manage our large and complex business operations. We acquired certain of these systems in connection with our acquisition of Alliance, including proprietary, real-time, fully integrated enterprise planning, warehouse management and retail inventory management systems.
We also deploy a variety of additional hardware and software to manage our business, including a complete suite of electronic data interchange tools that enable us to take client orders, transmit advanced shipping notifications, and place orders with our manufacturing trading partners. We also use an automated e-mail response system and automated call distribution system to manage our call center and conduct customer care services.
Software used in connection with our claims submission program and in connection with our subscriber information website was developed specifically for our use by a combination of in-house software engineers and outside consultants. We believe that certain elements of these software systems are proprietary to us. Other portions of these systems are licensed from a third party that assisted in the design of the system. We also receive systems service and upgrades under the license. We believe that we have obtained all necessary licenses to support our information systems.
We employ various security measures and backup systems designed to protect against unauthorized use or failure of our information systems. Access to our information systems is controlled through firewalls and passwords, and we utilize additional security measures to safeguard sensitive information. Additionally, we have backup power sources for blackouts and other emergency situations. Although we have never experienced any material failures or downtime with respect to any management information systems operations, any systems failure or material downtime could prevent us from taking orders and/or shipping product.
We have made strategic investments in material handling automation. Such investments include computer-controlled order selection systems that provide labor efficiencies and increase productivity and handling efficiencies. We have also invested in specialized equipment for our rapidly growing e-commerce accounts. We believe that in order to remain competitive, it will be necessary to invest and upgrade from time to time all of our information systems.
As of March 31, 2007, we had approximately 7,500 employees, of whom approximately 3,400 were full-time employees. Approximately 600 of our employees are covered by collective bargaining agreements that expire at various times through October 31, 2009. We believe our relations with our employees are good.
Included below is a summary of event(s) occurring after the end of the most recently complete fiscal year, but prior to the filing of this Form 10-K:
On February 14, 2007, our Board of Directors approved a plan to dispose of our custom wood manufacturing division, in order to better focus on our distribution, claiming, information and wire manufacturing businesses. We are currently negotiating with a potential purchaser in which our former Chairman of the Board and Chief Executive Officer holds an interest, however no assurance can be made that a transaction will occur. This potential buyer has submitted to the Company a Letter of Intent which provides for a purchase price of $10.0 million in cash, subject to a working capital adjustment, and a note for $3.5 million maturing over 10 years.
Set forth below and elsewhere in this Annual Report on Form 10-K and in other documents we file with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward looking statements contained in this Annual Report on Form 10-K.
A significant percentage of our sales are derived from a limited number of customers. In particular, for the year ended January 31, 2007, Barnes & Noble, Inc. accounted for approximately 19.6% of our total revenues.
We expect to continue to be dependent on a small number of customers for a substantial portion of our revenues. If any of these customers were to terminate their relationship with us, significantly reduce their purchases from us or experience problems in paying amounts due to us, it would result in a material reduction in our revenues and operating profits.
We will have significant working capital requirements principally to finance inventory, accounts receivable and new acquisitions. We are currently a party to a revolving credit facility with a syndicate of lenders arranged by Wells Fargo Foothill, Inc. In addition, we are extended trade credit by our suppliers.
Our business will depend on the availability of a credit facility and continued extension of credit by suppliers to support our working capital requirements. To maintain the right to borrow revolving loans and avoid a default under a credit facility, we will be required to comply with various financial and operating covenants and maintain sufficient eligible assets to support revolving loans pursuant to a specified borrowing base. Our ability to comply with these covenants or maintain sufficient eligible assets may be affected by events beyond our control, including prevailing economic, financial and industry conditions, and we may be unable to comply with these covenants or maintain sufficient eligible assets in the future. A breach of any of these covenants or the failure to maintain sufficient eligible assets could result in a default under these credit facilities. If we default, our lenders will no longer be obligated to extend revolving loans to us and could declare all amounts outstanding under our credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, our lenders could proceed against the collateral interest granted to them to secure that indebtedness. The results of such actions would have a significant negative impact on our results of operations and financial condition.
We are dependent on commercial freight carriers, primarily UPS, to deliver our products. If the operations of these carriers are disrupted for any reason, we may be unable to deliver our products to our customers on a timely basis. If we cannot deliver our products in an efficient and timely manner, our customers may reduce their orders from us and our revenues and operating profits could materially decline.
For the year ended January 31, 2007, our freight cost represented approximately 5.6% of our revenue. If freight costs were to increase and we were unable to pass that increase along to our customers due to competition within our industry, our financial results could materially suffer.
In a rising fuel cost environment, our freight costs may increase. If we are unable to pass the increased costs along to our customers, our results of operation may materially decline.
Making additional strategic acquisitions is part of our strategy. The ability to make acquisitions will depend upon identifying attractive acquisition candidates and, if necessary, obtaining financing on satisfactory terms. Acquisitions, including those that we have already made, may pose certain risks to us. These include the following:
· we may be entering markets in which we have limited experience;
· the acquisitions may be potential distractions to management and may divert company resources and managerial time;
· it may be difficult or costly to integrate an acquired business financial, computer, payroll and other systems into our own;
· we may have difficulty implementing additional controls and information systems appropriate for a growing company;
· some of the acquired businesses may not achieve anticipated revenues, earnings or cash flow;
· we may not achieve the expected benefits of the transactions including increased market opportunities, revenue synergies and cost savings from operating efficiencies;
· difficulties in integrating the acquired businesses could disrupt client service and cause us to lose customers;
· we may have unanticipated liabilities or contingencies from an acquired business;
· we may assume indebtedness of the acquired company that may leave the Company highly leveraged;
· we may be required to invest a significant amount into working capital of the acquired company;
· we may have reduced earnings due to amortization expenses, goodwill impairment charges, increased interest costs and costs related to the acquisition and its integration;
· we may finance future acquisitions by issuing common stock for some or all of the purchase price which could dilute the ownership interests of the stockholders;
· acquired companies will have to become, within one year of their acquisition, compliant with SEC rules relating to internal control over financial reporting adopted pursuant to the Sarbanes-Oxley Act of 2002;
· we may be unable to retain management and other key personnel of an acquired company; and
· we may impair relationships with an acquired companys, or our own, employees, suppliers or customers by changing management.
To the extent that the value of the assets acquired in any prior or future acquisitions, including goodwill or other identifiable intangible assets, becomes impaired, we would be required to incur impairment charges that would result in a material charge against our earnings. Such impairment charges could reduce our earnings and have a material adverse effect on the market value of our common stock. At the end of fiscal year 2007, the net book value of our goodwill and other identifiable intangibles was approximately $511.0 million. At the end of fiscal year 2007, certain customer lists, non-compete agreements and goodwill related to our In-Store Services segment were revalued and determined to be impaired. The impairment charges recorded in the fourth quarter of fiscal 2007 were approximately $32.7 million.
If we are unsuccessful in meeting the challenges arising out of our acquisitions, our business, financial condition and future results could be materially harmed.
WE DEPEND ON ACCESS TO ACCURATE INFORMATION ON RETAIL SALES OF MAGAZINES IN ORDER TO OFFER CERTAIN SERVICES TO OUR CUSTOMERS, AND WE COULD LOSE A SIGNIFICANT COMPETITIVE ADVANTAGE IF OUR ACCESS TO SUCH INFORMATION WERE DIMINISHED.
We use information concerning the retail sales of single copy magazines to:
· compare the revenue potential of various front-end fixture designs to assist our customers in selecting designs intended to maximize sales in the front-end;
· identify sales trends at individual store locations permitting us to provide just-in-time inventory replenishment and prevent stock outs; and
· offer both retailers and publishers information services, such as ICN and Cover Analyzer, and customized sales reporting.
We gain access to this information principally through relationships with A.C. Nielsen & Company, Barnes & Noble, Inc, Walgreen Company and The Kroger Company. We do not currently have written agreements with all of these providers. We also obtain a significant amount of information in connection
with our rebate claim submission services. Our access to information could be restricted as a result of the inability of any of our data partners to supply information to us or as a result of the discontinuation or substantial modification of the current incentive payment programs for magazines. If our access to information were reduced, the value of our information and design services could materially diminish and our publisher and retailer relationships could be negatively impacted.
Current technology allows consumers to buy music digitally from many providers such as Apple Computer (through iTunes), Music Match, Rhapsody, Microsoft (through MSN) and others. The sale of digital music has grown significantly in the past year, and the recording industry saw sales revenue for CDs decline significantly from 2001 to 2006. As this method of selling music increases in popularity and gains consumer acceptance, it may adversely impact our sales and profitability. The recording industry also continues to face difficulties as a result of illegal online file-sharing and downloading. While industry associations and manufacturers have successfully launched legal action against downloaders and file sharers to stop this practice, there can be no assurance of the effect of these lawsuits. File sharing and downloading, both legitimate and illegal, could continue to exert pressure on the recording industry and the demand for CDs. Additionally, as other forms of media become available for digital download, our sales and profitability attributable to CDs and DVDs may be adversely affected.
Recent advances in the technologies to deliver movies to viewers may adversely affect public demand for DVDs offered by us. For example, some digital cable providers and internet companies offer movies on demand with interactive capabilities such as start, stop and rewind. Direct broadcast satellite and digital cable providers have been able to enhance their on-demand offerings as a result of their ability to transmit over numerous channels. Although not as advanced as the digital distribution of music, Apple Computer (through iTunes) and others have begun to offer video content digitally. Apart from on-demand technology, the recent development and enhancement of personal video recorder technology with time-shifting technology (such as that used by TiVo and certain cable companies) has given viewers greater interactive control over broadcasted movies and other program types. Also, companies such as Blockbuster Entertainment and NetFlix are now offering subscription services which provide consumers the ability to rent VHS cassettes and DVDs for indefinite periods of time without being subject to late fees. If these methods of watching filmed entertainment increase in popularity and gain consumer acceptance, they may adversely impact sales and profits.
Each of our business units faces significant competition. Our Fulfillment group distributes home entertainment product in competition with a number of national and regional companies, including Anderson News Company, Anderson Merchandisers, L.P., Hudson News Company, News Group, Ingram Book Group, Inc., Ingram Entertainment, Inc., Handleman Company, and Baker & Taylor, Inc. Major record labels and film studios periodically compete with us by establishing direct trading relationships with the larger retail chains.
Our In-Store Services group competes in a highly fragmented industry with other manufacturers for wood and wire display fixture business. In addition, some of this groups information and management services may be performed directly by publishers and other vendors, retailers or distributors. Other information service providers, including A.C. Nielsen Company, Information Resources and Audit Bureau of Circulations, also collect sales data from retail stores. If these service providers were to compete with us,
given their expertise in collecting information and their industry reputations, they could be formidable competitors.
Some of our existing and potential competitors have substantially greater resources and greater name recognition than we do with respect to the market or market segments they serve. Because of each of these competitive factors, we may not be able to compete successfully in these markets with existing or new competitors. Competitive pressures may result in a decrease in the number of customers it serves, a decrease in its revenues or a decrease in its operating profits.
Approximately 4.4% of our total revenues from magazine distribution for the year ended January 31, 2007 were derived from the export of U.S. publications to overseas markets, primarily to the United Kingdom and Australia. In addition, approximately 4.4% of our gross domestic distribution of magazines for the year ended January 31, 2007, consisted of the domestic distribution of foreign publications imported for sale to U.S. markets.
The conduct of business internationally presents additional inherent risks including:
· unexpected changes in regulatory requirements;
· import and export restrictions;
· tariffs and other trade barriers;
· differing technology standards;
· resistance from retailers to our business practices;
· employment laws and practices in foreign countries;
· political instability;
· fluctuations in currency exchange rates;
· imposition of currency exchange controls; and
· potentially adverse tax consequences.
Any of these risks could adversely affect revenue and operating profits of our international operations.
Certain suppliers have adopted policies restricting the export of DVDs and CDs by domestic distributors. However, consistent with industry practice, we distribute our merchandise internationally. We would be adversely affected if a substantial portion of our suppliers enforced any restriction on our ability to sell our home entertainment content products outside the United States.
SUBSTANTIALLY ALL OF THE MAGAZINES DISTRIBUTED BY US ARE PURCHASED FROM FOUR SUPPLIERS AND OUR REVENUES COULD BE ADVERSELY AFFECTED IF WE ARE UNABLE TO RECEIVE MAGAZINE ALLOTMENTS FROM THESE SUPPLIERS.
Substantially all of the magazines distributed in the United States are supplied by or through one of four national distributors, Comag Marketing Group, LLC, Curtis Circulation Company, Kable Distribution Services, Inc. and Time Warner Retail Sales and Marketing, Inc. Each title is supplied by one of these national distributors to us and cannot be purchased from any alternative source. Our success is largely dependent on our ability to obtain product in sufficient quantities on competitive terms and conditions from each of the national distributors. In order to qualify to receive copy allotments, we are required to
comply with certain operating conditions, which differ between the specialty retail market and the mainstream market. Our ability to economically satisfy these conditions may be affected by events beyond our control, including the cooperation and assistance of our customers. A failure to satisfy these conditions could result in a breach of our purchase arrangements with our suppliers and entitle our suppliers to reduce our copy allotment or discontinue our right to receive product for distribution to our customers. If our supply of magazines were reduced, interrupted or discontinued, customer service would be disrupted and existing customers may reduce or cease doing business with us altogether, thereby causing our revenue and operating income to decline and result in failure to meet expectations.
A substantial portion of the DVD and CD products distributed by us are supplied by 5 film studios and 4 record labels. These products are proprietary to individual suppliers and may not be obtained from any alternative source. Our success depends upon our ability to obtain product in sufficient quantities on competitive terms and conditions from each of these major home entertainment labels and studios. If our supply of products were interrupted or discontinued, then customer service could be adversely affected and customers may reduce or cease doing business with us causing our sales and profitability to decline.
As is customary in the home entertainment content product industry, virtually all of our sales will be made on a sale or return basis. During the year ended January 31, 2007, approximately 60 out of every 100 magazine copies distributed domestically by Source Interlink and approximately 22 and 20 out of every 100 DVDs and CDs, respectively, distributed domestically by Alliance were returned unsold by their customers for credit; however, the sell-through rate can vary from period to period. Revenues from the sale of merchandise that we distribute are recognized at the time of delivery, less a reserve for estimated returns. The amount of the return reserve is estimated based on historical sell-through rates. If sell-through rates in any period are significantly less than historical averages, this return reserve could be inadequate. If the return reserve proved inadequate, it would indicate that actual revenue in prior periods was less than accrued revenue for such periods. This would require an increase in the amount of the return reserve for subsequent periods which may result in a reduction in operating income for such periods.
Our CD and DVD Fulfillment segment generated 30.8% of its total net sales in the fourth quarter of fiscal 2007 coinciding with the holiday shopping season. Factors that could adversely affect sales and profitability in the fourth quarter include:
· unavailability of, and low customer demand for, particular products;
· unfavorable economic and geopolitical conditions;
· inability to hire adequate temporary personnel;
· weather conditions;
· inability to anticipate consumer trends;
· weak new release schedules; and
· inability to maintain adequate inventory levels.
We depend upon the services of our interim co-chief executive officers and their relationships with customers and other third parties. The loss of these services or relationships could adversely affect our business and the implementation of our growth strategy. This in turn could materially harm our financial condition and future results. Although we have employment agreements with each of our interim co-chief executive officers, the services of these individuals may not continue to be available to the combined company.
To manage future growth, our management must continue to improve operational and financial systems and expand, train, retain and manage its employee base. We will likely be required to manage an increasing number of relationships with various customers and other parties. Our management may not be able to manage the companys growth effectively. If our systems, procedures and controls are inadequate to support our operations, our expansion could be halted and we could lose opportunities to gain significant market share. Any inability to manage growth effectively may harm our business.
Our business depends on the efficient and uninterrupted operation of our computer and communications software and hardware systems, including our replenishment and order regulation systems, and other information technology. If we were to fail for any reason or if we were to experience any unscheduled down times, even for only a short period, its operations and financial results could be adversely affected. We have in the past experienced performance problems and unscheduled down times, and these problems could recur. Our systems could be damaged or interrupted by fire, flood, hurricanes, power loss, telecommunications failure, break-ins or similar events. We have formal disaster recovery plans in place. However, these plans may not be entirely successful in preventing delays or other complications that could arise from information systems failure, and, if they are not successful, our business interruption insurance may not adequately compensate it for losses that may occur.
Many of our operations and services, including replenishment and order regulation systems, PIN, ICN, customer direct fulfillment and other information technology, involve the transmission of information over the Internet. Our business therefore will be subject to any factors that adversely affect Internet usage including the reliability of Internet service providers, which from time to time have operational problems and experience service outages.
In addition, one of the requirements of the continued growth over the Internet is the secure transmission of confidential information over public networks. Failure to prevent security breaches of our networks or those of our customers or well-publicized security breaches affecting the Internet in general could significantly harm our growth and revenue. Advances in computer capabilities, new discoveries in the field of cryptography or other developments may result in a compromise or breach of the algorithms we use to protect content and transactions or our customers proprietary information in its databases. Anyone who is able to circumvent our security measures could misappropriate proprietary and confidential information or could cause interruptions in our operations. We may be required to expend significant capital and other resources to protect against such security breaches or to address problems caused by security breaches.
Although we evaluate our internal control over financial reporting and disclosure controls and procedures as of the end of each fiscal quarter, we may not be able to prevent all instances of accounting errors or fraud in the future. Controls and procedures do not provide absolute assurance that all deficiencies in design or operation of these control systems, or all instances of errors or fraud, will be prevented or detected. These control systems are designed to provide reasonable assurance of achieving the goals of these systems in light of legal requirements, company resources and the nature of our business operations. These control systems remain subject to risks of human error and the risk that controls can be circumvented for wrongful purposes by one or more individuals in management or non-management positions. Our business could be seriously harmed by any material failure of these control systems.
THE DVD AND CD BUSINESS DEPENDS IN PART ON THE CURRENT ADVERTISING ALLOWANCES, VOLUME DISCOUNTS AND OTHER SALES INCENTIVE PROGRAMS, AND OUR RESULTS OF OPERATION COULD BE ADVERSELY AFFECTED IF THESE PROGRAMS WERE DISCONTINUED OR MATERIALLY MODIFIED.
Under terms of purchase prevailing in its industry, the profitability of the DVD and CD are enhanced by advertising allowances, volume discounts and other sales incentive programs offered by record labels and movie studios. Such content providers are not under long-term contractual obligations to continue these programs, and in 2003 one major record label eliminated advertising allowances and volume discounts on a limited number of stock keeping units. If record labels or movie studios, or both, decide to discontinue these programs, we would experience a significant reduction in operating profits.
Our largest stockholder, AEC Associates, L.L.C. beneficially owned approximately 34% of our outstanding voting power as of April 9, 2007. For as long as AEC Associates (together with its members and affiliates acting as a group) owns an aggregate of at least 10% of our outstanding common stock, AEC Associates will have certain additional director designation rights as further described in the risk factor entitled We have limitations on changes of control that could reduce your ability to sell our shares at a premium. For example, for actions that require a supermajority of the board, such as a change of control, AEC Associates designated directors may effectively have enough votes to prevent any such action from being taken by us. As a result, AEC Associates will have the ability through its ownership of our common stock and its representation on the board to exercise significant influence over our major decisions and over all matters requiring stockholder approval. AEC Associates may have interests that differ from those of our stockholders.
Our bylaws provide that the affirmative vote of at least 75% of its entire board will be required to (i) approve or recommend a reorganization or merger of our company in a transaction that will result in our stockholders immediately prior to such transaction not holding, as a result of such transaction, at least 50% of the voting power of the surviving or continuing entity, (ii) a sale of all or substantially all of our assets which would result in its stockholders immediately prior to such transaction not holding, as a result of such sale, at least 50% of the voting power of the purchasing entity, or (iii) a change in our bylaws. This requirement may prevent us from making changes and taking other actions that are subject to this
supermajority approval requirement. This requirement may limit our ability to pursue strategies or enter into strategic transactions for which the supermajority approval of the board cannot be obtained.
Our certificate of incorporation and bylaws currently contain provisions that could reduce the likelihood of a change of control or acquisition of our company, which could limit your ability to sell our shares at a premium or otherwise affect the price of our common stock. These provisions include the following:
· permit our board to issue up to 2,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions of that preferred stock;
· permit our board to issue up to 100,000,000 shares of common stock;
· require that a change of control of the company be approved by a supermajority of at least 75% of the members of the board;
· provide for a classified board of directors;
· permit the board to increase its own size and fill the resulting vacancies;
· limit the persons who may call special meetings of stockholders; and
· establish advance notice requirements for nominations for election to the board or for proposing matters that can be acted on by stockholders at stockholders meetings.
Our common stock is currently traded on the Nasdaq National Market. Our average daily trading volume for the three month period ending April 13, 2007 was approximately 279,000 shares. In the future, we may experience more limited daily trading volume. The trading price of our common stock has been and may continue to be volatile. The closing sale prices of our common stock, as reported by the Nasdaq National Market, have ranged from a high of $12.52 to a low of $7.16 for the 52-week period ending January 31, 2007. The closing sale price of our common stock, as reported by the Nasdaq National Market on April 13, 2007 was $6.90. Broad market and industry fluctuations may significantly affect the trading price of our common stock, regardless of our actual operating performance. The trading price of our common stock could be affected by a number of factors, including, but not limited to, announcements of new services, additions or departures of key personnel, quarterly fluctuations in our financial results, changes in analysts estimates of our financial performance, general conditions in our industry and conditions in the financial markets and a variety of other risk factors, including the ones described elsewhere in this Annual Report on Form 10-K. Periods of volatility in the market price of a companys securities sometimes result in securities class action litigation. If this were to happen to us, such litigation would be expensive and would divert managements attention. In addition, if we needed to raise equity funds under adverse conditions, it would be difficult to sell a significant amount of our stock without causing a significant decline in the trading price of our stock.
Our principal executive offices are located at 27500 Riverview Center Boulevard, Bonita Springs, Florida. As of April 3, 2007, we owned or leased approximately 1.1 million square feet of manufacturing facilities, 1.1 million square feet of distribution centers, 0.5 million in warehouses, and 0.1 million square feet of office space. The following table presents information concerning our principal properties:
We believe our facilities are adequate for our current level of operations and that all of our facilities are adequately insured.
We are party to routine legal proceedings arising out of the normal course of business. Although it is not possible to predict with certainty the outcome of these unresolved legal actions or the range of possible loss, we believe that none of these actions, individually or the in the aggregate, will have a material adverse effect on our financial condition, results of operations or liquidity.
No matters were submitted to a vote of stockholders during the fourth quarter of fiscal 2007.
Our common stock is quoted on the Nasdaq National Market under the symbol SORC.
The following table sets forth, for the periods indicated, the range of high and low bid prices for our common stock as reported by the Nasdaq National Market during the fiscal year shown. All such quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.
As of April 5, 2007, there were approximately 130 holders of record of our common stock.
We have never declared or paid dividends on our common stock. Our board of directors presently intends to retain all of our earnings, if any, for the development of our business for the foreseeable future. The declaration and payment of cash dividends in the future will be at the discretion of our board of directors and will depend upon a number of factors, including, among others, any restrictions contained in our credit facilities and out future earnings, operations, capital requirements and general financial condition and such other factors that our board of directors may deem relevant. Currently, our credit facilities prohibit the payment of cash dividends or other distributions on our capital stock or payments in connection with the purchase, redemption, retirement or acquisition of our capital stock.
The following table presents information about securities authorized for issuance under equity compensation plans as of January 31, 2007:
(a) Excludes securities to be issued upon exercise of outstanding options, warrants and rights.
The following selected consolidated financial data are only a summary and should be read in conjunction with our financial statements and related notes thereto and Managements Discussion and Analysis of Financial Condition and Results of Operations included in this Annual Report on Form 10-K. The consolidated statement of operations data for the years ended January 31, 2005, 2006 and 2007 and the balance sheet data as of January 31, 2006 and 2007, which have been prepared in accordance with accounting principles generally accepted in the U.S., are derived from our financial statements audited by BDO Seidman, LLP, an independent registered public accounting firm, which are included elsewhere in this Annual Report on Form 10-K. The consolidated statements of income data for the years ended January 31, 2003 and 2004 and the balance sheet data as of January 31, 2003, 2004 and 2005, which have been prepared in accordance with accounting principles generally accepted in the U.S., are derived from our audited financial statements which are not included in this Annual Report on Form 10-K. On February 28, 2005, we consummated our merger with Alliance Entertainment Corp. The results of operations of Alliance are included in the selected financial data presented below for the period beginning March 1, 2005 only. On May 10, 2005, we consummated our acquisition of Chas. Levy Circulating Co, LLC. The results of operations of Levy are included in the selected financial data presented below for the period beginning May 10, 2005 only. Also on March 30, 2006, we consummated our acquisitions of Anderson Mid-Atlantic News, LLC and Anderson SCN Services, LLC. The results of operations for Mid-Atlantic and SCN are included in the selected financial data presented below for the period beginning April 1, 2006 only. For a description of the merger of Source Interlink and Alliance and the acquisitions of Levy, Mid-Atlantic and SCN, please see the section entitled Managements Discussion and Analysis of Financial Condition and Results of Operations. Historical operating results are not necessarily indicative of the results that may be expected for any future period.
(a) 2003 and 2004 are restated for the discontinued operations as discussed in Note 8.
Throughout this section we discuss and refer to the following reportable segments:
· Magazine FulfillmentOur Magazine Fulfillment group provides domestic and foreign titled magazines to specialty retailers, such as bookstores and music stores, and to mainstream retailers, such as supermarkets, discount stores, drug stores, convenience stores and newsstands. This group also exports domestic titled magazines from more than 100 publishers to foreign markets worldwide. We provide fulfillment services to more than 40,000 retail stores, 11,000 of which also benefit from our selection and logistical procurement services.
· CD and DVD FulfillmentOur CD and DVD Fulfillment group sells and distributes pre-recorded music, videos, video games and related products to retailers, provides product and commerce solutions to retailers and provides customer-direct fulfillment and vendor managed inventory.
· In-Store ServicesThe in-store services segment designs, manufactures, ships, installs, removes and invoices participants in front-end wire fixture and custom wood display programs, provides claim filing services for rebates owed retailers from publishers and their agents and provides information and management services relating to retail magazine sales to U.S. and Canadian retailers and magazine publishers.
· Shared ServicesOur Shared Services group consists of overhead functions not allocated to the other groups. These functions include corporate finance, human resource, management information systems and executive management that are not allocated to the three operating groups. Upon completion of the consolidation of our administrative operations, we restructured our accounts to separately identify corporate expenses that are not attributable to any of our three main operating groups. Prior to fiscal year 2004, these expenses were included within our In-Store Services group.
This segment structure represents a change in organizational structure from that reported in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations in our Form 10-K for the fiscal year ended January 31, 2005. The segment organization presented herein corresponds to the financial and other reporting received by our chief operating decision maker. For additional financial and geographic information regarding our segments and a discussion of the change in organizational structure, see Note 17 Segment Information to our Consolidated Financial Statements.
The following events have occurred that have a material impact on the comparison of our results of operations for the year ended January 31, 2007 and the prior year:
We have performed four acquisitions during the last two fiscal years. The results of operations from the following acquired business are included in current year results of operations for a different number of months than they were included in the prior year:
· Alliance Entertainment Corp.Results from Alliance were included in fiscal 2007 earnings for 12 months compared to 11 months in fiscal 2006;
· Chas. Levy Circulating Co, LLCResults from Levy were included in fiscal 2007 earnings for 12 months compared to approximately nine months in fiscal 2006;
· Anderson Mid-Atlantic News, LLCResults from Mid-Atlantic were included in fiscal 2007 earnings for 10 months while no results from Mid-Atlantic were included in fiscal 2006; and
· Anderson SCN Services, LLCResults from SCN were included in fiscal 2007 earnings for 10 months while no results from SCN were included in fiscal 2006.
For more information on the above acquisitions, see Note 2Business Combinations and Asset Acquisitions to our Consolidated Financial Statements.
Effective November 10, 2006, S. Leslie Flegel, the Companys then Chairman of the Board of Directors and Chief Executive Officer, resigned from the Company and its Board of Directors pursuant to a Separation, Consulting and General Release Agreement dated November 12, 2006 (the Separation Agreement). The Companys Board of Directors has since named Michael R. Duckworth, a director of the Company, Chairman of the Board of Directors. The Companys then President and Chief Operating Officer, James R. Gillis, and the Companys then Executive Vice President and President and Chief Operating Officer of the Companys Alliance Entertainment Corporation subsidiary, Alan Tuchman, have since been named interim co-Chief Executive Officers. The Company recorded a charge to earnings of $9.6 million in the fiscal year ended January 31, 2007 related to Mr. Flegels separation from the Company.
In the fourth quarter of fiscal 2007, we amended our distribution agreement with a major customer of our magazine distribution segment such that revenue is no longer recognized upon the delivery of product less an allowance for returns but rather revenue is recognized when the sale occurs at retail. This transition to a scan-based trading relationship resulted in a one-time conversion charge, which had a negative impact on profitability of $16.2 million. The majority of this charge is the non-cash deferral of profits as a result of this change. Until the time of sale, the inventory is being carried on the Companys books at the product cost. We are optimistic that scan-based trading will ultimately reduce costs, result in a reduction in working capital, maximize retail productivity and throughput, and continue to enhance retailer relationships.
As a result of indications of potential impairment, we performed SFAS No. 142 and SFAS No. 144 impairment analyses, we determined that the customer list, non-compete agreement and goodwill of our In-Store Services reporting unit was impaired and consequently recorded a charge of approximately $1.7 million, $0.5 million and $30.6 million, respectively. These determinations were primarily the result of a change in managements expectations of the long-term outlook for that business unit, including increased life cycle for certain products, as well as decreasing operating profit margins. The combination of these factors had an adverse impact on the anticipated future cash flows of this reporting unit used in the impairment analysis performed during the fourth quarter of fiscal year 2007. The net carrying amount of the customer list was $1.25 million and goodwill $24.7 million at the end of the fourth quarter of fiscal year 2007, after the impairment charge was recorded.
In November 2004, we sold and disposed of our secondary wholesale distribution operation for $1.4 million, in order to focus more fully on our domestic and export distribution. All rights owned under the secondary wholesale distribution contracts were assigned, delivered, conveyed and transferred to the buyer, an unrelated third party. All assets and liabilities relating to our secondary wholesale distribution operation were not assumed by the buyer. We recognized a gain on sale of this business of $1.4 million ($0.8 net of tax) in the fourth quarter of fiscal year 2005.
The following amounts related to our Magazine Fulfillment segments discontinued operation (secondary wholesale distribution business) have been segregated from continuing operations and reflected as discontinued operations in each periods consolidated statement of income:
The Magazine Fulfillment group derives revenues from:
· selling and distributing magazines, including domestic and foreign titles, to specialty and mainstream retailers throughout the United States and Canada;
· exporting domestic titles internationally to foreign wholesalers or through domestic brokers;
· providing return processing services for major specialty retail book chains; and
· serving as an outsourced fulfillment agent and backroom operator for publishers.
The CD and DVD Fulfillment group derives revenues from:
· selling and distributing pre-recorded music, movies, video games and related products primarily to specialty and mainstream retailers throughout the United States;
· serving as an outsourced fulfillment agent and backroom operator for movie studios and record labels.
The In-Store Services group derives revenues from:
· designing, manufacturing and invoicing participants in front-end merchandising programs;
· providing claim filing services related to rebates owed to retailers from publishers or their designated agents;
· storing, shipping, installing, and removing front-end fixtures;
· designing, manufacturing and installing custom wood fixtures primarily for retailers; and
· providing information and management services relating to magazine sales to retailers and publishers throughout the United States and Canada.
The cost of revenues for the Magazine Fulfillment group consists of the costs of magazines purchased for resale less all applicable publisher discounts and rebates.
The cost of revenues for the CD and DVD Fulfillment group consists of the costs of CDs and DVDs purchased for resale less all applicable discounts and rebates.
The cost of revenues for the In-Store Services group includes:
· raw materials consumed in the production of display fixtures, primarily steel, wood and plastic components;
· production labor; and
· manufacturing overhead.
Selling, general and administrative expenses for each of the operating groups include:
· non-production labor;
· rent and office overhead;
· professional fees; and
· management information systems.
Expenses associated with corporate finance, human resources, certain management information systems and executive offices are included within the Shared Services group and are not allocated to the other groups.
Fulfillment freight consists of our direct costs of distributing magazines, CDs and DVDs by third-party freight carriers, primarily UPS ground service, and the cost of delivery by company-owned trucks. Third party freight rates are driven primarily by the weight of the copies being shipped and the distance between origination and destination.
Fulfillment freight is not disclosed as a component of cost of revenues, and, as a result, gross profit and gross profit margins are not comparable to other companies that include shipping and handling costs in cost of revenues.
Fulfillment freight has increased proportionately as the amount of product we distribute has increased. We anticipate the continued growth in our Magazine Fulfillment and CD and DVD Fulfillment groups will result in an increase in fulfillment freight. Generally, as pounds shipped increase, the cost per pound charged by third party carriers decreases.
During fiscal 2007, the Company incurred $3.7 million of expenses related to the planned consolidation of the backroom operations and marketing functions of the domestic mainstream distribution group from Lisle, IL to Bonita Springs, FL and the planned consolidation of one of its existing southern California distribution centers into a facility acquired in connection with the acquisition of SCN.
During fiscal 2005, the Company incurred $2.5 million of expenses related to distribution center relocations and a plant conversion. The Company began expansion into the mainstream retail market which resulted in distribution fulfillment centers in Milan, OH, San Diego, CA and Kent, WA being moved to Harrisburg, PA and Carson City, NV.
The following table presents comparative operating results for our CD and DVD Fulfillment group for the fiscal years ended January 31, 2007 and 2006:
NMthe result of the calculation is not meaningful
As discussed above, we acquired Alliance Entertainment Corp. on February 28, 2005. As such, results of operations for the year ended January 31, 2006 include only 11 months of activity, compared to 12 months in the year ended January 31, 2007. Increases in individual income statement line items for the CD and DVD fulfillment group result primarily from the timing of the acquisition during the year ended January 31, 2006.
Gross profit margin increased over the prior year primarily due to increased volume rebates and other vendor incentives.
Fulfillment freight increased as a percentage of revenues primarily due to increased fuel surcharges and a larger percentage of sales requiring overnight air shipments.
Operating margin increased primarily due to decreased bad-debt expense. During the fourth quarter of fiscal 2007, we reached a final favorable settlement of certain disputes with large customers that were reserved prior to the acquisition of Alliance. As a result of this final settlement, we reversed $3.3 million of bad-debt reserves and accrued expenses.
The following table presents comparative operating results for our Magazine Fulfillment group for the fiscal years ended January 31, 2007 and 2006:
NMthe result of the calculation is not meaningful
Revenues from domestic specialty distribution decreased primarily due to the change in revenue recognition discussed above.
As discussed above, we acquired Levy in May 2005 and SCN and Mid-Atlantic in March 2006. Therefore, fiscal 2006 results include only nine months of results from Levy and no results from SCN and Mid-Atlantic and fiscal 2007 results include 12 months of results from Levy and ten months of results from SCN and Mid-Atlantic. Increases in individual income statement line items for the Magazine fulfillment group as well as revenues from domestic mainstream distribution result primarily from the timing of the acquisitions during fiscal 2007 and fiscal 2006.
Gross profit margin increased partly due to the benefit of certain industry-wide pricing programs designed to compensate distributors for distributing lower-priced titles.
Fulfillment freight increased as a percentage of revenues and operating margin decreased primarily due to the change in revenue recognition discussed above, as all expenses associated with distributing magazines for this account have been recorded as incurred while recognition of revenues has been deferred until the magazines scan. Fulfillment freight as a percentage of revenues was also impacted by higher fuel surcharges. In addition, operating margin felt the impact of the integration and relocation expenses discussed above.
The following table presents comparative operating results for our In-Store Services group for the fiscal years ended January 31, 2007 and 2006:
NMthe result of the calculation is not meaningful
Revenues from claim filing are recognized at the time the claim is paid. Claim filing revenues decreased primarily due to the timing of the cash payments received on claims. Information services revenue increased $0.1 million over the prior year to $2.0 million.
Revenues from wire manufacturing increased primarily due to an increased number of front-end fixture purchases as certain retailers replaced their aging fixtures.
Revenues from wood manufacturing decreased primarily due fewer store openings and remodelings performed by our significant customers.
Gross profit margin increased primarily due to the increase in wire manufacturing revenues discussed above.
Operating margin decreased primarily due to the impairment of goodwill and intangible assets discussed above, partially offset by increased operating margins related to increased wire manufacturing revenues discussed above.
The following table presents comparative operating results for our Shared Services group for the fiscal years ended January 31, 2007 and 2006:
NMthe result of the calculation is not meaningful
Selling, general and administrative expenses increased primarily due to a charge of $9.6 million related to the resignation of our CEO described above, $1.1 million in expenses associated with the Companys exploration of strategic alternatives and $0.4 million in expenses associated with the Companys adoption of FAS 123(R) and to support the growth of the business due to recent acquisitions described above.
Disposal of land, buildings and equipment includes a $0.5 million loss associated with the sale of a former manufacturing facility and a $0.4 million loss associated with the termination of the Companys aircraft lease.
Interest expense, net increased $5.9 million from $6.6 million to $12.5 million primarily due to increased borrowings on our revolving credit facility due to the acquisitions of SCN and Mid-Atlantic described above. Also contributing to the increase are higher weighted average borrowing rates versus the prior year.
Other income is comprised of items that are outside the normal course of business. Therefore, comparison between periods is not meaningful.
Income tax expense decreased $20.1 million from $14.6 million to $(5.2) million primarily due to a decrease in taxable income. Our effective benefit rate was 17.4% in the year ended January 31, 2007 compared to an effective tax rate of 50.4% for the year ended January 31, 2006. The change in effective rate is due primarily to the non-deductible nature of a large portion of the goodwill and intangible assets impairment charge taken in fiscal 2007 and to the effects of certain customary permanent differences on our decreased income before income taxes. The revision of the treatment of certain timing differences also impacted our effective tax rate.
The following table presents comparative operating results for our CD and DVD Fulfillment group for the fiscal years ended January 31, 2006 and 2005:
NMthe result of the calculation is not meaningful
We acquired Alliance on February 28, 2005. As such, no results of operations were recorded from our CD and DVD Fulfillment group during fiscal 2005. Therefore, all increases in individual income statement line items are attributable to the acquisition.
The following table presents comparative operating results for our Magazine Fulfillment group for the fiscal years ended January 31, 2006 and 2005:
NMthe result of the calculation is not meaningful
Revenues from domestic specialty distribution decreased primarily due to an overall decrease in efficiencies in our two major bookstore chains.
Revenues from domestic mainstream distribution increased primarily due to significantly increasing our presence in the mainstream market in May 2005, with the acquisition of Chas. Levy Circulating Company, a leading magazine wholesaler based in Chicago, IL with distribution centers in Chicago, Lancaster, PA, Brainerd, MN, and City of Industry, CA.
Revenues from export distribution decreased primarily due to lower overall efficiencies.
Gross profit margins decreased primarily due to the change in sales mix due to the increase in revenues in the mainstream distribution channel. The mainstream distribution channel generally has lower gross margins than the specialty distribution channel due to certain publisher rebates that are available to the specialty distribution channel that are not available in the domestic mainstream distribution channel.
Selling, general and administrative costs increased primarily due to the expansion of the groups mainstream distribution infrastructure. Expenses as a percentage of revenues increased from 10.2% to 12.1%. The increase relates primarily to a high concentration of total sales being derived from mainstream accounts in fiscal 2006. As part of our mainstream distribution channel we provide in-store merchandising services to the majority of retailer accounts.
Fulfillment freight percent of revenues decreased primarily due to the expansion of our distribution into the mainstream distribution channel, which overall has lower freight costs as a percent of distribution than the specialty market due to concentration of retail accounts in a single marketing region and the utilization of our own fleet vs. servicing national accounts via third party delivery.
The following table presents comparative operating results for our In-Store Services group for the fiscal years ended January 31, 2006 and 2005:
NMthe result of the calculation is not meaningful
Revenues from claim filing are recognized at the time the claim is paid. The decrease in revenues in the fiscal year ended January 31, 2006 relate to the timing of the cash payments received on the claims.
Information services revenue increased by approximately $1.0 million over the prior year relating to additional information product contracts being entered into in the current year.
Revenues from wire manufacturing declined due to the cyclical nature of the industry and use of fixtures beyond the historical life cycle. Major chains have historically purchased new front-end fixtures every three years; however, the use of the front end fixtures has been extending beyond this life cycle.
Revenues from wood manufacturing increased due to an increase in the number of store openings and remodelings performed by our significant customers.
Gross profit margin decreased primarily due to decreased revenues from the wire manufacturing business, coupled with an increase in lower profit margin projects completed within the wire manufacturing business versus the prior year.
Selling, general and administrative expenses decreased primarily due to a decrease in general operating expenses.
The following table presents comparative operating results for our Shared Services group for the fiscal years ended January 31, 2006 and 2005:
NMthe result of the calculation is not meaningful
Selling, general and administrative expense increased primarily due to increases in corporate overhead and compensation as a result of the merger with Alliance and the acquisition of Levy.
Interest expense increased $5.2 million, or 331.4%, for the fiscal year ended January 31, 2006 compared to the fiscal year ended January 31, 2005. This increase was due to significantly higher borrowings in the fiscal year ended January 31, 2006, related to the Alliance and Levy acquisitions and higher average interest rates.
Other income (expense) consists of items outside of the normal course of operations. Due to its nature, comparability between periods is not generally meaningful.
The effective tax rates on income from continuing operations for the years ended January 31, 2006 and January 31, 2005 were 50.4% and 14.6%, respectively. The increase in effective tax rates and differences from statutory rates relate primarily to certain non-deductible charges, and gains associated
with the Alliance merger and a reduction in a valuation allowance in the fiscal year ended January 31, 2005.
Our primary sources of cash include receipts from our customers, borrowings under our credit facilities and from time to time the proceeds from the sale of common stock.
Our primary cash requirements for the CD and DVD Fulfillment and Magazine Fulfillment group consist of the cost of CDs and DVDs, magazines and the cost of freight, labor and facility expense associated with our distribution centers.
Our primary cash requirements for the In-Store Services group consist of the cost of raw materials, labor, and factory overhead incurred in the production of front-end and custom wood displays, the cost of labor incurred in providing our claiming, design and information services and cash advances funding our Advance Pay program. Our Advance Pay program allows retailers to accelerate collections of their rebate claims through payments from us in exchange for the transfer to us of the right to collect the claim. We then collect the claims when paid by publishers for our own account.
Our primary cash requirements for the Shared Services group consist of salaries, professional fees and insurance not allocated to the operating groups.
The following table presents a summary of our significant obligations and commitments to make future payments under debt obligations and lease agreements due by fiscal year as of January 31, 2007 (in thousands).
(a) Interest is calculated using the prevailing weighted average rate on our outstanding debt at January 31, 2007, using the required payment schedule.
The following table presents a summary of our commercial commitments and the notional amount expiration by period:
The following table shows comparative operating cash flow components for the years ended January 31, 2007, 2006 and 2005:
In addition to the non-cash add-backs to and (deductions from) net income required to reconcile net income from cash used in operating activities, working capital changes for the year ended January 31, 2007 are as follows:
The overall increase in inventory was primarily due to an increase in inventories within our Magazine Fulfillment group, due in part to the change in revenue recognition discussed above, partially offset by a decrease in inventory within our CD and DVD Fulfillment group of $1.6 million.
The decrease in accounts payable and other liabilities was primarily due to a decrease in accounts payable within our Magazine Fulfillment group of $20.1 million, primarily due to the timing of the acquisitions of SCN and Mid Atlantic. A decrease in accounts payable of $15.0 million within our CD and DVD Fulfillment group, related primarily to the timing of vendor payments and shifting product mix toward more DVDs, which have historically had less-favorable payment terms. These decreases are partially offset by an increase in within our Shared Services group of $11.0 million, due primarily to the accrual of charges associated with the resignation of our CEO in November 2006.
The increase in income tax receivable is primarily attributable to the accrual of income tax refunds receivable during the year ended January 31, 2007.
The overall decrease in accounts receivable is primarily attributable to a decrease in accounts payable within our Magazine fulfillment group of $16.5 million related to the revenue recognition change described above, offset by the timing of customer payments.
In addition to the non-cash add-backs to and (deductions from) net income required to reconcile net income from cash used in operating activities, working capital changes for the year ended January 31, 2006 are as follows:
The overall increase in accounts payable of $81.5 million for the fiscal year ended January 31, 2006 was primarily due to the seasonality of CD and DVD Fulfillment and Magazine Fulfillment groups. An increase in accounts payable in our CD and DVD Fulfillment group of $56.3 million was due to holiday season purchasing on extended terms provided by the major record labels and studios.
The Magazine Fulfillment Group had an increase in accounts payable of approximately $36.5 million due primarily to the cyclical nature of the Mainstream Magazine distribution business.
The increase in accounts receivable for the fiscal year ended January 31, 2006 of $33.3 million and the increase in inventories of $41.5 million relates primarily to increased distribution and sales levels in our CD and DVD Fulfillment and Magazine Fulfillment, for the holiday season.
In addition to the non-cash add-backs to and (deductions from) net income required to reconcile net income from cash used in operating activities, working capital changes for the year ended January 31, 2005 are as follows:
The increase in accounts receivable for the fiscal year ended January 31, 2005 was primarily due to an increase in accounts receivable in our Magazine Fulfillment group of $6.6 million. The increase was due to an overall increase in distribution levels, especially in the last month of the quarter, more lenient payment terms offered to a significant customer in exchange for more favorable pricing, and partially offset by $13.8 million increase in the sales return reserve from the end of fiscal 2004.
The In-Store Services Group had an increase in accounts receivable of approximately $2.2 million due primarily due to the seasonal nature of the wire manufacturing business, which generally has the highest receivable balance in the third quarter, and increased revenues from the wood manufacturing business.
The decrease in accounts payable and accrued expenses for the fiscal year ended January 31, 2005 of $24.8 million relates primarily to a $12.5 million increase of purchase return reserves in our Magazine Fulfillment group.
The following table shows comparative investing cash flow components for the years ended January 31, 2007, 2006 and 2005:
Net cash used in investing activities for the fiscal year ended January 31, 2007 consisted primarily of cash paid to acquired SCN and Mid-Atlantic, capital expenditures of $13.4 million related primarily to our CD and DVD Fulfillment groups ongoing effort to streamline its distribution process and our Shared Services groups ongoing effort to improve information technology infrastructure. Net cash used by investing activities also included the net acquisition of claims by our In-Store Services group of $7.1 million.
Net cash used in investing activities for the fiscal year ended January 31, 2006 consisted primarily of cash paid to acquire Levy of $45.0 million, net of cash acquired and capital expenditures of $13.1 million. Capital expenditures related primarily to our CD and DVD Fulfillment group and its ongoing effort to streamline its distribution process. Net cash used by investing activities also included the net acquisition of claims by our In-Store Services group of $7.9 million. These cash consuming activities were partially offset by net cash acquired of $16.8 million upon completion of our merger with Alliance.
For the fiscal year ended January 31, 2005, cash used in investing activities included capital expenditures of $7.1 million, which in part related to our expansion of our distribution facilities in
Harrisburg, Pennsylvania and Carson City, Nevada. Our advance pay program generated net cash flow of $4.0 million in the fiscal year ended January 31, 2005. In addition, we collected $6.8 million from the prior operator of our export distribution business during 2005. The initial advances were made as part of the agreement to collect the prior operators receivables and pay outstanding payables so as to create a seamless transition for both the customers and suppliers. In addition, we incurred approximately $2.6 million in acquisition costs related to the acquisition of Alliance Entertainment Corp.
In August 2004, we acquired all customer-based intangibles (i.e., all market composition, market share and other value) respecting claiming and information services of PROMAG Retail Services, LLC (Promag) for approximately $13.2 million. Of the $13.2 million purchase price, $10.0 million was funded from a term loan discussed below and $0.75 million in a promissory note payable over a three year period to Promag. Promag provides claim filing services related to rebates owed retailers from publishers or their designated agent throughout the United States and Canada.
In September 2004, we acquired substantially all of the assets and liabilities of Empire State News Corp. (Empire), a magazine wholesaler in northwest New York state, for approximately $5.0 million. The purchase price consisted of $3.4 million of cash paid and $1.6 million of deferred consideration in the form of two notes payable ($1.2 million) and deferred compensation, subject to finalization of working capital adjustments in accordance with the purchase agreement.
In November 2004, the Company entered into an agreement to terminate the leases under the magazine import and the magazine export agreements and acquire all import and export assets, naming rights and other intangibles including a non-compete by the seller. The purchase price of the import and export businesses was approximately $14.1 million (after an allowed reduction of the purchase price for the payments made by the Company under the prior leases agreements). The purchase price was comprised of $4.2 million paid in cash on the last business day of November 2004 and additional notes payable in the principal amount of $7.7 million.
Our borrowing agreements limit the amount of our capital expenditures in any fiscal year.
Outstanding balances on our credit facility fluctuate partially due to the timing of the retailer rebate claiming process and our Advance Pay program, the seasonality of our CD and DVD Fulfillment and wire manufacturing business, and the payment cycle of the magazine distribution business. Because the magazine distribution business and Advance Pay program cash requirement peak at our fiscal quarter ends, the reported bank debt levels usually are the maximum level outstanding during the quarter.
Payments under our Advance Pay program generally occur just prior to our fiscal quarter end. The related claims are not generally collected by us until 90 days after the advance is made. As a result, our funding requirements peak at the time of the initial advances and decrease over the next 90 days as the cash is collected on the related claims.
Sales of CDs and DVDs are traditionally highest during our fourth quarter (the holiday season), while returns are highest during our first quarter. Consequently, working capital needs for the home entertainment products marketplace are typically highest in our third quarter due to increases in inventories purchased for the holiday selling season and extension of credit terms to certain customers. Historically, the CD and DVD Fulfillment segment has financed their working capital needs through cash generated from operations, extended terms from suppliers and bank borrowings.
Within our magazine distribution business, our significant customers pay weekly, and we pay our suppliers monthly. As a result, funding requirements peak at the end of the month when supplier payments are made and decrease over the course of the next month as our receivables are collected.
The wire manufacturing business is seasonal because most retailers prefer initiating new programs before the holiday shopping season begins, which concentrates revenues in the second and third quarter. Receivables from these fixture programs are generally collected from all participants within 180 days. We are usually required to tender payment on the costs of these programs (raw material and labor) within a shorter period. As a result, our funding requirements peak in the second and third fiscal quarters when we manufacture the wire fixtures and decrease significantly in the fourth and first fiscal quarters as the related receivable are collected and significantly less manufacturing activity is occurring.
The following table shows comparative investing cash flow components for the years ended January 31, 2007, 2006 and 2005:
Financing activities in the fiscal year ended January 31, 2007 consisted primarily of borrowings on our revolving credit facility of $71.5 million, borrowings under notes payable of $3.1 million and proceeds from issuance of common stock of $2.2 million, partially offset by payments on notes payable of $21.3 million. Payments on notes payable are composed primarily of payments on notes issued to the former owner of SCN and Mid-Atlantic.
Financing activities in the fiscal year ended January 31, 2006 consisted primarily of borrowings on our revolving credit facility of $25.7 million and borrowings under notes payable of $20.6 million, including a mortgage of $20.0 million. These cash providing activities were partially offset by the reduction in checks issued against future borrowings on credit facilities of $13.5 million and payments on notes payable of $23.4 million, primarily related to the modification of the Wells Fargo Foothill credit facility and the repayment of a mortgage loan. Finally, the exercise of employee stock options for the fiscal year generated approximately $5.0 million.
Financing activities in the fiscal year ended January 31, 2005 consisted of proceeds from the sale of 3.8 million shares of common stock. The proceeds generated from the issuance of common stock were approximately $40.5 million (net of underwriting and related expenses). We utilized a portion of these proceeds to repay the Wells Fargo Foothill original term loan, the Hilco Capital note payable and the notes payable to former owners. Total payments on notes payable in the current year was $24.0 million. For the fiscal year ended January 31, 2005, borrowings on the credit facilities totaled $7.6 million and a term loan in the amount of $10.0 million was issued related to the Promag transaction. In addition, the cash provided by the activities noted above was offset by a $12.2 million decrease in checks issued and outstanding at January 31, 2005. Finally, the exercise of employee stock options for the fiscal year generated approximately $5.9 million.
At January 31, 2007, our total debt obligations were $154.4 million, excluding outstanding letters of credit. Debt consists primarily of our amounts owed under a revolving credit facility, a mortgage loan with Wachovia Bank, the notes payable related to the acquisitions of the magazine import and export businesses and Levy, and equipment loans.
On February 28, 2005, in conjunction with our merger with Alliance, we entered into an amended and restated secured financing arrangement with Wells Fargo Foothill, Inc., as arranger and administrative agent (the Working Capital Loan Agent) for each of the lenders that may become a participant in such arrangement, and their successors and assigns (the Working Capital Lenders) pursuant to which the Working Capital Lenders will make revolving loans (Working Capital Loans) to us and our subsidiaries of up to $250 million (Advances) and provide for the issuance of letters of credit. The terms and conditions of the arrangement are governed primarily by the Amended and Restated Loan Agreement dated February 28, 2005 by and among us, our subsidiaries, and Wells Fargo (the Amended and Restated Loan Agreement).
The proceeds of the Working Capital Loans were used to (i) finance transaction expenses incurred in connection with the merger of Source Interlink and Alliance and the reincorporation of Source Interlink into Delaware, (ii) repay certain existing indebtedness of Alliance and its subsidiaries, (iii) repay certain existing indebtedness of Source Interlink to Wells Fargo under our previous credit facility (including, without limitation, a $10 million term loan) and (iv) for working capital and general corporate purposes, including the financing of acquisitions.
Outstanding Advances bear interest at a variable annual rate equal to the prime rate announced by Wells Fargo Bank, National Associations San Francisco office, plus a margin of between 0% and 1.00% based upon a ratio of the Registrants EBITDA to interest expense (Interest Coverage Ratio). We also have the option of selecting up to five traunches of at least $1 million each to bear interest at LIBOR plus a margin of between 2.00% and 3.00% based upon our Interest Coverage Ratio. To secure repayment of the Working Capital Loans and other obligations of ours to the Working Capital Lenders, we and our subsidiaries granted a security interest in all of our personal property assets to the Working Capital Loan Agent, for the benefit of the Working Capital Lenders. The Working Capital Loans mature on October 31, 2010.
The commitment of the Working Capital Lenders to make Advances is subject to the existence of sufficient eligible assets to support such Advances under a specified borrowing base formula and compliance with, among other things, certain financial covenants. Under the Amended and Restated Loan Agreement, we are required to maintain a specified minimum level of EBITDA and compliance with specified fixed charge coverage and debt to EBITDA ratios. In addition, we are prohibited, without consent from the Working Capital Lenders, from:
(i) incurring additional indebtedness or liens on our personal property assets;
(ii) engaging in any merger, consolidation, acquisition or disposition of assets or other fundamental corporate change;
(iii) permitting a change of control of us;
(iv) paying any dividends or making any other distribution on capital stock or other payments in connection with the purchase, redemption, retirement or acquisition of capital stock;
(v) changing our fiscal year or methods of accounting; and
(vi) making capital expenditures in excess of $19.3 million during any fiscal year.
Additional events of default under the Amended and Restated Loan Agreement include, among others:
(i) failure to pay our obligations to the Working Capital Lenders or to otherwise observe its covenants under the Amended and Restated Loan Agreement and other loan documents,
(ii) any of our subsidiaries becomes insolvent or bankrupt or has any material portion of its assets seized or encumbered, and
(iii) a material breach or default under any of the Registrants material contracts, including contracts for indebtedness.
The balance on the credit facility at January 31, 2007 was $116.5 million. At January 31, 2007, the Company had availability of $92.7 million. We believe that availability under this credit facility will be sufficient to finance our operation during the coming year.
We do not engage in transactions or arrangements with unconsolidated or other special purpose entities.
Managements Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Senior management has discussed the development, selection and disclosure of these estimates with the audit committee of the board. Actual results may differ from these estimates under different assumptions and conditions.
Management believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.
For traditional accounts, we record a reduction in revenue for estimated CD, DVD, and magazine sales returns and a reduction in cost of sales for estimated purchase returns. Estimated sales returns are based on historical sales returns and daily point-of-sale data from significant customers. The purchase return estimate is calculated from the sales return reserve based on historical gross profit. If the historical data we use to calculate these estimates does not properly reflect future results, revenue and/or cost of sales may be misstated.
We do not record a reduction in revenue for estimated magazine sales returns or a reduction in cost of sales for estimated purchase returns for scan-based accounts. Scan-based accounts are accounts which we bill retailers only for magazines that are ultimately sold to their customers.
We provide for potential uncollectible accounts receivable based on customer-specific information and historical collection experience. If market conditions decline, actual collection experience may not meet expectations and may result in increased bad debt expenses.
The carrying value of our net deferred tax assets assumes that we will be able to generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions. If these estimates and assumptions change in the future, we may be required to increase or decrease valuation allowances against our deferred tax assets resulting in additional income tax expenses or benefits.