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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
------------------
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934
FOR THE FISCAL YEAR ENDED MARCH 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
Commission File Number 0-22982
-------------------
NAVARRE CORPORATION
(Exact name of registrant as specified in its charter)
MINNESOTA 41-1704319
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
7400 49TH AVENUE NORTH, NEW HOPE, MN 55428
(Address of principal executive offices)
(763) 535-8333
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
- -------------------------- ------------------------------------------
COMMON STOCK, NO PAR VALUE NASDAQ NATIONAL MARKET
Securities registered pursuant to Section 12(g) of the Act:
NONE
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the Registrant is an accelerated filer. Yes [ ]
No [X]
The aggregate market value of the voting stock held by non-affiliates of the
Registrant at September 30, 2003 was $51,806,695 based on the closing sale price
on such date of $2.84 per share.
The Registrant had 26,600,469 shares of Common Stock, no par value, outstanding
at June 18, 2004.
DOCUMENTS INCORPORATED BY REFERENCE
Items 10, 11, 12, 13 and 14 of Part III of this Annual Report on Form 10-K
incorporate certain information by reference from the Registrant's definitive
Proxy Statement to be filed with the Securities and Exchange Commission not
later than 120 days after the conclusion of the registrant's last fiscal year,
which ended March 31, 2004.
NAVARRE CORPORATION
FORM 10-K
TABLE OF CONTENTS
PART I
Page
Item 1. Business..............................................................................................3
Item 2. Properties...........................................................................................15
Item 3. Legal Proceedings....................................................................................16
Item 4. Submission of Matters to a Vote of Security Holders..................................................19
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters................................19
Item 6. Selected Financial Data..............................................................................21
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................22
Item 7A. Quantitative and Qualitative Disclosures About Market Risk...........................................31
Item 8. Financial Statements and Supplementary Data..........................................................32
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................32
Item 9A. Controls and Procedures..............................................................................32
PART III
Item 10. Directors and Executive Officers of the Registrant...................................................32
Item 11. Executive Compensation...............................................................................32
Item 12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters.....................................................................32
Item 13. Certain Relationships and Related Transactions.......................................................33
Item 14. Principal Accountant Fees and Services...............................................................33
PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.....................................33
Signatures...........................................................................................38
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PART I
ITEM 1. BUSINESS
References in this Form 10-K to "we," "us," "our," "our Company," and "Navarre"
mean Navarre Corporation and our subsidiaries, unless the context otherwise
requires.
GENERAL
Navarre Corporation, a Minnesota corporation formed in 1983, publishes and
distributes a broad range of home entertainment and multimedia products,
including personal computer ("PC") software, audio and video titles and
interactive games. Our business is divided into two business segments --
Distribution and Publishing. Our distribution business is operated through
Navarre Corporation. Our publishing business is operated through our Encore
Software and BCI Eclipse entities. Through these business segments we maintain
and leverage strong relationships throughout the publishing and distribution
chain. Our broad base of customers includes (i) wholesale clubs, (ii) mass
merchandisers, (iii) other third-party distributors, (iv) computer specialty
stores, (v) music specialty stores, (vi) book stores, (vii) office superstores,
and (viii) electronic superstores. Our customer base includes over 500
individual customers with over 18,000 locations, certain of which are
international locations.
Through our Distribution business, we distribute and provide fulfillment
services in connection with a variety of finished goods that are provided by our
vendors, which include a variety of publishers, independent and major music
labels, and movie studios. These vendors provide us with PC software, CD and DVD
audio, DVD and VHS video, video games and accessories. Our Distribution business
focuses on providing retailers and publishers with high-quality services for the
broad, efficient distribution of these products, including vendor-managed
inventory, Electronic Data Interchange services, fulfillment services, cross
docking and assumed receipt, and retailer-oriented marketing services.
Through our Publishing business we are the exclusive licensee or owner of
PC software, CD and DVD audio, DVD and VHS video, and video game titles. Our
Publishing business licenses, packages, markets and sells these products to
third-party distributors, directly to retailers, as well as to our Distribution
business. We expect that our recent agreement to distribute Riverdeep's
educational and interactive products will increase the size of this segment.
During fiscal years 2004, 2003, and 2002, sales for our Distribution
business accounted for 94.5%, 99.0% and 100.0% of net sales, while sales of the
Publishing business accounted for 9.7%, 4.1% and 0.0% of net sales,
respectively. During fiscal 2004 and fiscal 2003, after the elimination of
intercompany sales, our Publishing business accounted for 5.5% of net sales and
1.0% of net sales.
We derive no material revenue from businesses located outside the United
States and Canada.
Our recent acquisitions include the July 2002 acquisition of the primary
assets of Encore Software, Inc. ("Encore") and the November 2003 acquisition of
all the assets of BCI Eclipse, LLC ("BCI Eclipse"). Encore is an interactive
publisher in the video game and PC CD-ROM markets. The assets we purchased
included certain fixed assets, inventory, receivables and contract rights
related to Encore's business. The assets are held by a majority-owned Navarre
subsidiary, which has been named Encore Software, Inc. BCI Eclipse is a provider
of niche DVD and video products. The acquisition of BCI Eclipse is part of our
strategy for growth with expanded content ownership and gross margin
enhancement. BCI Eclipse's proprietary audio products contribute to our
direction of enhancing products and services to our new mass merchandise
customers. BCI Eclipse's DVD/Video and audio collection represents exclusively
licensed titles and in-house produced CDs and DVDs. The assets purchased by us
included certain fixed assets, intellectual property, inventory, receivables and
contract rights related to BCI Eclipse's business. The assets are held by a
majority-owned Navarre subsidiary, which has been named BCI Eclipse Company,
LLC.
We were incorporated in Minnesota in 1983. Our corporate headquarters is
located at 7400 49th Avenue North, in New Hope, Minnesota, 55428, our telephone
number is (763) 535-8333, our facsimile number is (763) 504-1107 and our
web-site address is www.navarre.com.
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SIGNIFICANT SEASONALITY/CUSTOMERS
Traditionally, our third quarter (October 1-December 31) has accounted for
our largest quarterly revenue figures and a substantial portion of our earnings.
Our third quarter accounted for approximately 32.2%, 32.5% and 38.2% of our
revenues for the fiscal years ended March 31, 2004, 2003 and 2002, respectively,
and approximately 40.4%, 69.5% and 120.9% of our net income for the fiscal years
ended March 31, 2004, 2003 and 2002, respectively. As a distributor of products
ultimately sold to retailers, our business is affected by the pattern of
seasonality common to other suppliers of retailers, particularly during the
holiday selling season.
In each of the past several years, we have had one or more customers that
accounted for 10% or more of our net sales. During the fiscal year ended March
31, 2004, sales to three customers, Best Buy, CompUSA and Sam's Clubs,
represented approximately 17%, 12% and 11% of our total sales, respectively.
OUR MARKETS
DISTRIBUTION SEGMENT
PC Software
According to NPD Intelect (formerly P.C. Data), the PC software industry
achieved $3.68 billion in sales in 2003. Categories that experienced an increase
over 2003 were system utilities, business, finance and personal productivity
products. During the past fiscal year, we added several publishers to our
distribution roster. We presently have relationships with PC software publishers
such as Microsoft Corporation, Symantec Corporation, Roxio, Inc., Adobe Systems
Inc., Network Associates, Inc., Dreamcatcher Interactive, Inc., Sony Online
Entertainment, Inc., Delorme and THQ. These relationships are important to our
Distribution business and during the fiscal year ended March 31, 2004 each of
these publishers accounted for more than $5,000,000 in revenues. In the case of
Symantec, sales under this agreement accounted for more than $38 million in net
sales in the fiscal year ended March 31, 2004.
While we have agreements in place with each of these parties, they are
generally short-term agreements lasting one to three years in term, they
generally cover the right to distribute in the United States and Canada, they do
not restrict the publisher from distributing their products through other
distributors or directly to retailers and they do not guarantee product
availability to us for distribution. Our agreements with these publishers
provide us with the ability to purchase the publisher's products at a reduced
wholesale price and for us to provide a variety of distribution and fulfillment
services in connection with the publisher's products. We intend to continue to
seek to add publishers that will increase our market share across all categories
of the PC software industry.
Video Games
We continued to expand our distribution of console-based video games in
fiscal 2004. In 2003, United States sales in the interactive entertainment
industry decreased 2.7% to $10 billion from $10.3 billion in 2002. According to
industry researcher UBS Warburg, the industry is estimated to reach $31 billion
in worldwide sales by 2005. Relationships with vendors such as Square Enix USA,
Inc. are important to our growth.
Major Label Music
According to the Recording Industry Association of America ("RIAA"), audio
and music video product shipped to domestic markets was $11 billion in calendar
2003. Industry sources indicate that approximately 83% of the unit shipments are
derived from major recording labels controlled by five major companies. Those
companies are Warner-Elektra-Atlantic Corp., Sony Music Entertainment Inc., EMI
Music Marketing, Bertelsmann Music Group, and Universal Music & Video
Distribution Corp. Generally, these companies control distribution of their
products through major music retail chains and other channels. We distribute
major label music to wholesale clubs and mass merchant retailers on a
non-exclusive basis through our Distribution business.
Independent Music
The independent segment of the music industry currently represents
approximately 17% of total music product. We are one of a limited number of
large independent distribution companies that represent independent
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labels exclusively on a regional or national basis. These companies provide
products and services to the nation's leading music specialty stores and
wholesalers. They provide unique services to their labels and artists including
financing, manufacturing, marketing, promotion and access to North American
retailers.
We continue to seek to increase our market share of the independent
distribution business by continuing to seek higher quality music labels and to
provide greater service to our customers, in addition to providing content
ownership and licensing opportunities. Relationships with independent music
labels such as CMH Records, Inc., Studio Distribution, Inc. and Cleopatra
Records, Inc. are also important to our Distribution business. We have exclusive
distributions agreements in place with certain of these labels that allow us to
retain a percentage of amounts received in connection with the sale of the
products provided by these labels. Among other customary provisions, these
agreements provide us with full returnability of the products, the right for us
to retain a reserve against potential returns of products, and requirements that
the label provide discounts, rebates and price protections.
Major Studio DVD
According to Video Business, the home video industry totaled $22 billion
in sales in 2003. DVD sales accounted for $12 billion, an increase of 46% from
2002. Relationships with Universal Distribution Corp., Twentieth Century Fox
Home Entertainment and Buena Vista Home Video are important to our growth of our
Distribution business.
PUBLISHING
In July 2002 and November 2003, we acquired the Encore and the BCI Eclipse
businesses. Encore is a publisher of entertainment and education PC products and
BCI Eclipse is a provider of niche DVD/video products. Both of these businesses
exclusively own or license and produce their PC/DVD/video products. In April of
2004, we entered into an exclusive co-publishing agreement with Riverdeep Inc.
for the sales and marketing of Riverdeep's interactive products in the
educational and productivity markets, which includes products published under
the Broderbund and The Learning Company labels.
E-COMMERCE
During fiscal year 2004, we continued to expand the number of electronic
commerce ("e-commerce") customers for whom we perform fulfillment and
distribution. These services include sales of PC software, prerecorded music and
DVD/VHS videos and video games. Our business-to-business web-site
www.navarre.com integrates on-line ordering and deployment of text and visual
product information, and has been enhanced to allow for easier user navigation
and ordering.
RECENT DEVELOPMENTS
RECENT CHANGE IN BUSINESS STRUCTURE
Prior to our purchase of BCI Eclipse, we had two segments - Home
Entertainment Products and Encore. Following our purchase of BCI Eclipse, we
treated the BCI Eclipse business as a third segment. Shortly after filing
financial information for our third quarter ended December 31, 2003, we decided
to combine the Encore and BCI Eclipse segments and relabel our segments. Thus,
we relabeled the Home Entertainment Products segment as "Distribution" and the
combined BCI Eclipse and Encore segments into a segment called "Publishing." We
believe that the new labels and combined segments more closely align the
Company's divisions based on their actual functions.
SECURITIES OFFERING
In December 2003, we completed a private placement to institutional and
other accredited investors of 2,631,547 shares of common stock and 657,887
shares of common stock issuable upon exercise of warrants. We sold the
securities for $4.75 per share for total proceeds of approximately $12,500,000
and net proceeds of approximately $11,735,000. The per share price of $4.75
represented a discount of approximately 15% of the closing price of our common
stock on the date the purchase was completed. The net proceeds were used to
5
discharge our approximate $6.6 million debt to Hilco Capital, LP incurred in
connection with the BCI Eclipse acquisition and the remainder was made available
for, among other things, general working capital needs.
The warrants issued to the placement investors are five-year warrants
exercisable at any time after the sixth month anniversary of the date of
issuance at $7.00 per share. The warrants contain customary anti-dilution
provisions and a cashless exercise provision that is applicable only if a
registration statement permitting sale of the underlying shares is not then
available. In addition, we have the right after the first anniversary date of
the warrant to require cash exercise of the warrant if, among other things, the
volume weighted average price of our common stock exceeds $12.00 per share for
each of 30 consecutive trading days. Furthermore, each warrant includes a
provision that limits the number of shares obtainable upon exercise to ensure
that the holder does not exceed 4.99% and 9.99% of our issued and outstanding
shares of common stock.
We issued to our agent in the private placement, Craig-Hallum Capital
Group, LLC, a warrant to purchase 131,577 shares. The warrant expires on
December 14, 2005 and is exercisable at $7.00 per share. The warrant contains
customary anti-dilution and piggyback registration rights, although, if the
shares underlying the warrant are included in any registration statement filed
pursuant to the placement purchasers registration rights agreement, then those
registration rights and obligations apply to the agent's warrant. The warrant
does not contain a cashless exercise provision and includes a mandatory exercise
provision that allows us to require exercise in full of the warrant within ten
days of notice that the average closing price of our common stock is equal to or
greater than $10.50 per share for any 30 consecutive trading days. We exercised
the mandatory exercise provision on June 9, 2004 and the warrant was exercised
on June 10, 2004.
On April 28, 2004, we registered for resale by the selling shareholders
the shares of common stock and the shares of common stock issuable upon exercise
of the warrants issued in the private placement under a registration statement
on Form S-3. This registration statement also covered the registration of
131,577 shares issuable upon the exercise of the agent's warrant as well as
320,000 shares issuable upon the exercise of a warrant issued to Hilco Capital,
LP, which provided financing in connection with our November 2003 acquisition of
the assets of BCI Eclipse and 1,000,000 shares issued in connection with the BCI
Eclipse acquisition.
RECENT SENIOR MANAGEMENT PROMOTIONS AND NEW DIRECTORS
We recently made several promotions amongst our senior management team. In
February 2004, Brian Burke, the Senior Vice President/General Manager of Navarre
Distribution, was promoted to Chief Operating Officer - Distribution; Cary
Deacon, our Corporate Relations Officer, assumed the newly-created position of
Chief Operating Officer - Publishing; and Jim Gilbertson, our Vice President and
Chief Financial Officer, was appointed to our Board of Directors to serve until
our next annual shareholder meeting. In addition, on April 22, 2004, Alfred Teo
resigned from our Board of Directors and on May 20, 2004, the Board of Directors
appointed Timothy R. Gentz to serve as a director until our next annual
shareholder meeting. Mr. Gentz was also appointed to serve on the Governance and
Audit Committees of the Board.
COMPETITION
All aspects of our business are highly competitive. Our competitors
include other national and regional distributors, as well as some suppliers that
sell directly to retailers. Some of these competitors have substantially greater
financial and other resources than we do. Our ability to effectively compete in
the future depends upon a number of factors, including our ability to: (i)
obtain exclusive national distribution contracts and licenses with independent
labels, studios, content owners, artists and manufacturers; (ii) maintain our
margins and volume; (iii) expand our sales through a varied range of products
and personalized services; (iv) anticipate changes in the marketplace including
technological developments and successfully continue our ability to distribute
products in light of these developments; (v) continue to provide our varied
retail customers with specialized services; and (vi) maintain operating expenses
at an appropriate level.
In the personal computer software industry, we face competition from a
number of distributors including Ingram Micro, Inc., Tech Data Corporation and
Atari, Inc. as well as from manufacturers and publishers that sell directly to
retailers. In the prerecorded music industry, we face competition from the five
major label distribution companies, as well as other national independent
distributors, such as Koch Entertainment, RED Music Distribution,
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Alternative Distribution Alliance ("ADA"), Ryko Distribution, and Caroline
Distribution, as well as from other entities that sell directly to retailers.
We believe that the distribution of PC software, prerecorded music, DVD
Video and video games will remain highly competitive and the keys to growth and
profitability will be: (i) customer service, (ii) continued focus on
improvements and operating efficiencies, (iii) the ability to develop
proprietary products, and (iv) the ability to attract higher quality artists and
software publishers. We also believe that over the next several years, both the
personal computer software distribution industry and prerecorded music
distribution industry, particularly on the independent side, will continue to
further consolidate.
The market for Internet content providers is highly competitive and
rapidly changing. We expect that competition between suppliers to Web retailers
will continue to intensify. We support numerous Internet retailers, including
traditional music retail chains, record labels and independents with web sites
on the Internet.
OUR STRATEGY
Our goal is to expand our distribution and publishing of products on an
international basis, including music, software, video games and DVDs. We intend
to achieve this goal by: (i) increasing the number and quality of national
distribution arrangements with vendors supplying home entertainment product;
(ii) developing further PC software and DVD licensing arrangements to expand our
high margin publishing business; (iii) expanding our business through strategic
acquisitions in areas or in businesses that complement our existing businesses;
(iv) continuing to deliver high levels of service to our retail customers; (v)
continuing to improve our efficiencies and technologies at our state-of-the-art
distribution center; and (vi) utilizing the Internet to expand the appeal of our
products to a broader customer base.
Our strategy also includes growth through the acquisition of complementary
businesses. At present, we have no plans, proposals or arrangements to acquire
any complementary business and we may not be able to identify suitable
acquisition candidates.
EMPLOYEES
As of June 1, 2004, we had 441 employees, including 145 in administration,
finance and merchandising, 75 in sales and marketing and 221 in distribution.
BACKLOG
Because our products are shipped in response to orders, we do not maintain
any significant backlog.
ENVIRONMENTAL MATTERS
We do not anticipate any material effect on our capital expenditures,
earnings or competitive position due to compliance with government regulations
involving environmental matters.
FORWARD-LOOKING STATEMENTS / IMPORTANT RISK FACTORS
We make written and oral statements from time to time regarding our
business and prospects, such as projections of future performance, statements of
management's plans and objectives, forecasts of market trends, and other matters
that are forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 and Section 21F of the Securities Exchange Act of 1934.
Statements containing the words or phrases "will likely result," "are expected
to," "will continue," "is anticipated," "estimates," "projects," "believes,"
"expects," "anticipates," "intends," "target," "goal," "plans," "objective,"
"should" or similar expressions identify forward-looking statements, which may
appear in documents, reports, filings with the Securities and Exchange
Commission, including this Annual Report on Form 10-K, news releases, written or
oral presentations made by officers or other representatives made by us to
analysts, shareholders, investors, news organizations and others and discussions
with management and other representatives of us. For such statements, we claim
the protection of the safe harbor for forward-looking statements contained in
the Private Securities Litigation Reform Act of 1995.
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Our future results, including results related to forward-looking
statements, involve a number of risks and uncertainties. No assurance can be
given that the results reflected in any forward-looking statements will be
achieved. Any forward-looking statement made by or on behalf of us speaks only
as of the date on which such statement is made. Our forward-looking statements
are based on assumptions that are sometimes based upon estimates, data,
communications and other information from suppliers, government agencies and
other sources that may be subject to revision. Except as required by law, we do
not undertake any obligation to update or keep current either (i) any
forward-looking statement to reflect events or circumstances arising after the
date of such statement, or (ii) the important factors that could cause our
future results to differ materially from historical results or trends, results
anticipated or planned by us, or which are reflected from time to time in any
forward-looking statement which may be made by or on behalf of us.
In addition to other matters identified or described by us from time to
time in filings with the SEC, there are several important factors that could
cause our future results to differ materially from historical results or trends,
results anticipated or planned by us, or results that are reflected from time to
time in any forward-looking statement that may be made by or on behalf of us.
Some of these important factors, but not necessarily all important factors,
include the following:
OUR FOUNDER SIGNIFICANTLY INFLUENCES OUR BUSINESS OPERATIONS. THE LOSS OF OUR
FOUNDER COULD AFFECT THE DEPTH, QUALITY AND EFFECTIVENESS OF OUR MANAGEMENT. IN
ADDITION, IF WE FAIL TO ATTRACT AND RETAIN QUALIFIED PERSONNEL, THE DEPTH,
QUALITY AND EFFECTIVENESS OF OUR MANAGEMENT TEAM AND EMPLOYEES COULD BE
NEGATIVELY AFFECTED.
Eric H. Paulson, our President, Chief Executive Officer and founder, has
been with us since our inception in 1983. Although we have invested a
substantial amount of time and effort in developing our total management team
and Mr. Paulson's employment agreement extends through March 31, 2007, the loss
of Mr. Paulson, by death or disability, could affect management's ability to
continue to effectively operate our business.
Our ability to enhance and develop markets for our current products and to
introduce new products to the marketplace also depends on our ability to attract
and retain qualified management personnel. We compete for such personnel with
other companies and organizations, many of which have substantially greater
capital resources and name recognition than us. We may not be successful in
recruiting or retaining such personnel, which could have a material adverse
effect on our business.
SALES TO THREE OF OUR CUSTOMERS ACCOUNTED FOR APPROXIMATELY 40% OF OUR TOTAL
REVENUE FOR THE FISCAL YEAR ENDED MARCH 31, 2004 AND APPROXIMATELY 48% OF TOTAL
REVENUE FOR FISCAL 2003. A REDUCTION IN SALES TO ANY OF THESE THREE CUSTOMERS
COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR SALES AND PROFITABILITY.
In each of the past several years, we have had one or more customers that
accounted for 10% or more of our net sales. During the fiscal year ended March
31, 2003, sales to three customers, Best Buy, CompUSA and Sam's Clubs,
represented approximately 19%, 15% and 14% of our total sales, respectively. For
the fiscal year ended March 31, 2004, these three customers accounted for
approximately 17%, 12% and 11% of our total sales, respectively.
We are a non-exclusive supplier to each of our customers and there can be
no assurance that we will continue to recognize a significant amount of revenue
from sales to any specific customer. If we are unable to continue to sell our
products to all or any of these three customers or are unable to maintain our
sales to these customers at current levels, and are unable to find other
customers to replace these sales, there would be an adverse impact on our
revenues and profitability.
A POOR HOLIDAY SELLING SEASON COULD ADVERSELY AFFECT OUR SALES AND
PROFITABILITY.
Traditionally, our third quarter (October 1-December 31) has accounted for
our largest quarterly revenue figures and a substantial portion of our earnings.
Our third quarter accounted for approximately 32.2%, 32.5% and 38.2% of our
revenues for the fiscal years ended March 31, 2004, 2003 and 2002, respectively,
and approximately 40.4%, 69.5% and 120.9% of our net income for the fiscal years
ended March 31, 2004, 2003 and 2002, respectively. As a distributor of products
ultimately sold to retailers, our business is affected by the pattern of
seasonality common to other suppliers of retailers, particularly during the
holiday selling season. Because of this seasonality, if we experience a weak
holiday season, our financial results could be negatively affected.
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THE LOSS OF A SIGNIFICANT VENDOR COULD ADVERSELY EFFECT THE PRODUCTS WE HAVE
AVAILABLE TO DISTRIBUTE, AND CORRESPONDINGLY, COULD NEGATIVELY AFFECT OUR SALES.
Relationships with PC software publishers such as Microsoft Corporation,
Symantec Corporation, Roxio, Inc., Adobe Systems Inc., Network Associates, Inc.,
Dreamcatcher Interactive, Inc. Sony Online Entertainment, Inc., Delorme, and THQ
are important to our Distribution business, and during the fiscal years ended
March 31, 2004 and 2003, each of these publishers accounted for more than $5.0
million in net sales. In the case of Symantec, sales under our agreement with
Symantec accounted for more than $38.0 million in net sales in the fiscal year
ended March 31, 2004. While we have agreements in place with each of these
parties, they are generally short-term agreements lasting one to three years in
term, they generally cover the right to distribute in the United States and
Canada, they do not restrict the publisher from distributing their products
through other distributors, or directly to retailers and they do not guarantee
product availability to us for distribution. These agreements provide the
Company with the ability to purchase the publisher's products at a reduced
wholesale price and for the Company to provide a variety of distribution and
fulfillment services in connection with the publisher's products. If we were to
lose our right to distribute products of our PC software publisher, our revenues
and profitability could be adversely impacted.
Relationships with independent music labels, such as CMH Records, Inc.,
Studio Distribution, Inc. and Cleopatra Records, Inc., are also important to our
Distribution business. We have exclusive distribution agreements in place with
these labels that allow us to retain a percentage of amounts received in
connection with the sale of the products provided by these labels. Among other
customary provisions, these agreements provide us with full returnability of the
products, the right for us to retain a reserve against potential returns of
products, and requirements that the label provide discounts, rebates and price
protections.
If we are unable to continue to sell products to one, or more, of our
publishers of independent music labels, there could be an adverse impact on our
revenues and profitability.
THE FAILURE TO FINANCE OUR SIGNIFICANT WORKING CAPITAL NEEDS COULD ADVERSELY
EFFECT A NUMBER OF ASPECTS RELATED TO OUR BUSINESS SUCH AS OUR ABILITY TO OBTAIN
PRODUCTS TO SELL OR FINANCE ACCOUNTS RECEIVABLES. IT COULD ALSO NEGATIVELY
AFFECT OUR ABILITY TO REMAIN CURRENT ON AMOUNTS DUE TO OUR VENDORS.
As a distributor and publisher of prerecorded music and personal computer
software products, we purchase products directly from manufacturers for resale
to retailers. As a result, we have significant working capital requirements,
principally to finance inventory and accounts receivable. These working capital
needs will expand as inventory and accounts receivable increase in response to
our growth. Although we believe we have obtained financing sufficient to meet
our working capital requirements to date, the failure to finance our working
capital needs or the failure to obtain additional financing upon favorable terms
when required in the future could adversely affect our business as the cost of
replacement financing may be very expensive or not available which could curtail
our distribution or publishing activities.
In the past, we have periodically relied upon bank borrowings to finance
our expansion, primarily for inventory and accounts receivable. Although on
March 31, 2004, 2003 and 2002, we had no debt, we have a credit facility in the
amount of $40.0 million in place with General Electric Credit Corporation (GECC)
and, at times, borrow to finance working capital requirements during the year.
Under the terms of our credit facility with GECC, borrowings are dependent upon
the eligibility of accounts receivable and inventory, and certain other
covenants in the discretion of the lender. We believe that it may be necessary
for us to acquire additional financing in the future depending upon the growth
of our business and the possible financing of acquisitions. If we were unable to
borrow under the credit facility and were unable to secure additional financing,
our future growth and profitability would be adversely affected.
THE LOSS OF A SOFTWARE DEVELOPER OR MANUFACTURER COULD NEGATIVELY CHANGE OUR
PRODUCT OFFERING AND ACCORDINGLY REDUCE OUR REVENUES.
We distribute interactive software under distribution agreements with
software developers and manufacturers. Our continued growth and success depends
partly upon our ability to procure and renew these agreements and to sell the
underlying software. There can be no assurance that we will enter into new
distribution agreements with developers and/or manufacturers or that we will be
able to sell software under existing distribution
9
agreements. Further, current distribution agreements may be terminated and not
replaced. The loss of a software developer or manufacturer could negatively
affect our product offering and accordingly our sales.
THE CONTINUED GROWTH AND BREADTH OF OUR EXCLUSIVE DISTRIBUTION BUSINESS COULD BE
NEGATIVELY AFFECTED IF WE FAILED TO SECURE NEW DISTRIBUTION AGREEMENTS WITH
RECORDING ARTISTS.
Our Distribution division makes a portion of its sales as a result of
exclusive distribution agreements with recording artists. Our continued growth
and success depend partly upon our ability to procure and renew these agreements
and to sell the underlying recordings. In addition, we depend upon artists and
labels to generate additional quality recordings. In order to procure future
distribution agreements, we regularly review artists and labels. There is no
assurance that we will sign such artists and labels to distribution agreements
or that we will be able to sell recordings under existing distribution
agreements. Further, there can be no assurance that any current distribution
agreements will be renewed or that current agreements will not be terminated.
A DECREASE IN THE POPULARITY OF PC SOFTWARE COULD NEGATIVELY AFFECT OUR
REVENUES.
A large portion of our recent sales increase has been due to increased
sales of PC software. A decrease in the need or desirability of customer
purchase of such software could negatively affect our sales.
EXCESSIVE PRODUCT RETURNS OR INVENTORY OBSOLESCENCE COULD SIGNIFICANTLY REDUCE
OUR SALES OR PROFITABILITY.
We maintain a significant investment in product inventory. Like other
companies operating in our industry, our product returns are significant when
expressed as a percentage of revenues. Our agreements with suppliers generally
permit us to return products that are in the suppliers' current product listing.
Adverse financial or other developments with respect to a particular supplier
could cause a significant decline in the value and marketability of our
products, and could make it difficult for us to return products to a supplier
and recover our initial product acquisition costs. Such an event could have a
material adverse effect upon our business and financial results. We maintain a
sales return reserve based on our trailing twelve month sales returns by product
line. We have historically experienced an actual return rate ranging from 14% to
20%, depending upon the product, which we believe is in line with industry
practice. In the past, these levels have been adequate to cover potential
returns, but there can be no assurance that our reserves will be adequate in the
future.
OUR ACQUISITION STRATEGY COULD RESULT IN DISRUPTIONS TO OUR BUSINESS BY, AMONG
OTHER THINGS, DISTRACTING MANAGEMENT TIME AND DIVERTING FINANCIAL RESOURCES.
One of our growth strategies is the acquisition of complementary
businesses. At present, we have no plans, proposals or arrangements to acquire
any complementary business and we may not be able to identify suitable
acquisition candidates, or if we do, we may not be able to make such
acquisitions on commercially acceptable terms or at all. If we make
acquisitions, a significant amount of management time and financial resources
may be required to complete the acquisition and integrate the acquired business
into our existing operations. Even with this investment of management time and
financial resources, an acquisition may not produce the revenue, earnings or
business synergies that we anticipated. Acquisitions involve numerous other
risks including: assumption of unanticipated operating problems or legal
liabilities, problems integrating the purchased operations, technologies or
products, diversion of management's attention from our core businesses, adverse
effects on existing business relationships with suppliers and customers,
incorrect estimates made in the accounting for acquisitions and amortization of
acquired intangible assets which would reduce future reported earnings, and
potential loss of customers or key employees of acquired businesses.
WE OPERATE IN A HIGHLY COMPETITIVE INDUSTRY AND COMPETE WITH LARGE NATIONAL
FIRMS. FURTHER COMPETITION COULD, AMONG OTHER THINGS, REDUCE OUR SALES VOLUME OR
MARGINS OR BOTH.
The Distribution segment, comprised of the prerecorded music and the PC
software industries, is highly competitive. Our competitors include other
national and regional distributors as well as suppliers that sell directly to
retailers. These competitors include the distribution affiliates of Time-Warner,
Sony Corporation, Thorn/EMI, Bertelsmann A.G., Ingram Micro and Tech Data
Corporation. Many of these competitors have substantially greater financial and
other resources than we have. Our ability to effectively compete in the future
depends upon a number of factors, including our ability to:
10
- obtain exclusive national distribution contracts and licenses with
independent labels and manufacturers;
- maintain our margins and volume;
- expand our sales through a varied range of products and personalized
services;
- anticipate changes in the marketplace including technological
developments; and
- maintain operating expenses at an appropriate level.
Our failure to adequately perform one or more of these tasks may materially harm
our business.
In addition, competition in the prerecorded music and PC software
distribution industries is intense and is often based on price. Distributors,
such as us, generally experience low gross and operating margins. Consequently,
our profitability is highly dependent upon achieving expected sales levels as
well as effective cost and management controls. Any erosion in our gross profit
margins could harm our financial results.
TECHNOLOGY DEVELOPMENTS, PARTICULARLY IN THE ELECTRONIC DOWNLOADING ARENA, MAY
ADVERSELY AFFECT OUR SALES, MARGINS, LIQUIDITY AND RESULTS OF OPERATIONS.
Prerecorded music and PC software have traditionally been marketed and
delivered on a physical delivery basis. Traditionally, all our revenues have
been generated from sales to retail and wholesale channels. If, in the future,
these products are increasingly marketed and delivered through technology
transfers, such as "electronic downloading" through the Internet or another
delivery mechanism, then our retail and wholesale distribution business could be
negatively impacted as we presently do not do business in this distribution
channel. As physical and electronic distribution grows through Internet
resellers, competition between suppliers to electronic retailers in traditional
ways will intensify and likely negatively impact our sales and margins.
Furthermore, we may be required to spend significant capital to enter or
participate in this delivery channel. If we are unable to develop necessary
supplier relationships with electronic retailers or are unable to develop
relationships to facilitate electronic distribution of software and music, our
business may be materially harmed.
INCREASED COUNTERFEITING AND FREE OR LOW COST MUSIC DOWNLOADS MAY NEGATIVELY
AFFECT THE DEMAND FOR OUR PRODUCTS AND SERVICES.
The recorded music industry continues to be adversely affected by
counterfeiting of both audiocassettes and CDs, piracy and parallel imports, and
also by websites and technologies that allow consumers to electronically
download and access music from these sources. Increased proliferation of these
alternative access methods to these products could impair our ability to
generate revenues and could cause our business to suffer.
OUR BUSINESS PRESENTLY IS DEPENDENT ON TRADITIONAL METHODS OF MUSIC, CD AND DVD
PRODUCT DISTRIBUTION AND ANY SIGNIFICANT CHANGE IN TRADITIONAL DISTRIBUTION
METHODS COULD NEGATIVELY AFFECT CONSUMER DEMAND FOR THE PRODUCTS WE DISTRIBUTE.
Our current sales strategy will continue to be successful only if our
wholesale and retail customers continue to purchase products through us rather
than directly from manufacturers, through other distributors or through other
means of distribution. Customers and retailers are constantly searching for ways
to lower costs in an attempt to maintain competitive prices and meet the pricing
demands of consumers. Our business could be adversely affected if our customers
decide to purchase directly from manufacturers, other distributors or other
distribution channels rather than from us.
WE CANNOT OFFER ANY ASSURANCE THAT SIGNIFICANT GROWTH WILL OCCUR IN OUR
PUBLISHING SEGMENT.
We have grown our Publishing segment substantially over the past two years
through acquisitions and a recent agreement. Accordingly, this segment's
historical financial performance may not be indicative of future performance and
this segment may experience a large variability in results.
11
We have grown our Publishing segment significantly over the past two years
with the acquisitions of Encore (July 2002) and BCI Eclipse (November 2003) and
the recent exclusive, five-year co-publishing agreement with Riverdeep (April
2004). Our discussions of changes in financial position and results of
operations of this segment may not be indicative of future performance and this
segment's financial results may vary in future quarters as we integrate these
new lines of business. Furthermore, as these new lines of business represent new
opportunities and challenges, we may encounter difficulties in the operation of
this segment that could negatively affect this segment's financial condition and
results of operation. Investors should not place undue reliance on the past
performance of our Publishing segment or rely on statements of expected growth
in this segment.
WE MAY NOT BE ABLE TO ADEQUATELY ADJUST OUR COST STRUCTURE IN A TIMELY FASHION
IN RESPONSE TO A DECREASE IN DEMAND, WHICH MAY CAUSE OUR PROFITABILITY TO
SUFFER.
We seek to continually institute more effective operational and expense
controls to reduce selling, general and administrative, or SG&A, expenses as a
percentage of net sales. However, a significant portion of our SG&A expense is
comprised of personnel, facilities and costs of invested capital. Historically,
we have monitored and controlled the growth in operating costs in relation to
overall net sales growth and continue to pursue and implement process and
organizational changes to provide sustainable operating efficiencies. However,
in the event of a significant downturn in net sales, we may not be able to exit
facilities, reduce personnel, or improve business processes, or make other
significant changes to our cost structure without significant disruption to our
operations or without significant termination and exit costs. Additionally,
management may not be able to implement such actions, if at all, in a timely
manner to offset a shortfall in net sales and gross profit. As a result, our
profitability may suffer.
WE ARE DEPENDENT ON A VARIETY OF INFORMATION SYSTEMS AND A FAILURE OF THESE
SYSTEMS COULD DISRUPT OUR BUSINESS AND HARM OUR REPUTATION AND NET SALES.
We depend on a variety of information systems for our operations. These
systems support a number of our operational functions, including:
- inventory management;
- order processing;
- shipping;
- receiving; and
- accounting.
Although we have not in the past experienced material system-wide failures
or downtime of any of our information systems, failures or significant downtime
could prevent us from taking customer orders, printing product pick-lists,
and/or shipping product. It could also prevent customers from accessing our
price and product availability information. From time to time we may acquire
other businesses having information systems and records, which may be converted
and integrated into our information systems. This can be a lengthy and expensive
process that results in a material diversion of resources from other operations.
In addition, because our information system is comprised of a number of legacy,
internally developed applications, it can be harder to upgrade, and may not be
adaptable to commercially available software. Particularly as our needs or
technology in general evolve, we may experience greater than acceptable
difficulty or cost in upgrading our information system, or we may be required to
replace it entirely.
We also rely on the Internet for a percentage of our orders and
information exchanges with our customers. The Internet and individual websites
can experience disruptions and slowdowns. In addition, some websites have
experienced security breakdowns. To date, our website has not experienced any
material breakdowns, disruptions or breaches in security; however, we cannot
assure that this will not occur in the future. If we were to experience a
security breakdown, disruption or breach that compromised sensitive information,
this could harm our relationship with our customers or suppliers. Disruption of
our website or the Internet in general could impair our order
12
processing or more generally prevent our customers and suppliers from accessing
information. This could cause us to lose business.
We believe that customer information systems and product ordering and
delivery systems, including Internet-based systems, are becoming increasingly
important in the distribution of technology products and services. As a result,
we are continually enhancing our customer information systems by adding new
features, including on-line ordering through the Internet. However, we offer no
assurance that competitors will not develop superior customer information
systems or that we will be able to meet evolving market requirements by
upgrading our current systems at a reasonable cost, or at all. Our inability to
develop competitive customer information systems or upgrade our current systems
could cause our business and market share to suffer.
WE HAVE SIGNIFICANT CREDIT EXPOSURE TO OUR RESELLER CUSTOMERS AND NEGATIVE
TRENDS IN THEIR BUSINESSES COULD CAUSE US SIGNIFICANT CREDIT LOSS.
As is customary in many industries, we extend credit to our reseller
customers for a significant portion of our net sales. Resellers have a period of
time, generally 30 to 60 days after date of invoice, to make payment. We are
subject to the risk that our reseller customers will not pay for the products
they have purchased. The risk that we may be unable to collect on receivables
may increase if our reseller customers experience decreases in demand for their
products and services or otherwise become less stable, due to adverse economic
conditions. If there is a substantial deterioration in the collectibility of our
receivables or if we cannot obtain credit insurance at reasonable rates or are
unable to collect under existing credit insurance policies, our earnings, cash
flows and our ability to utilize receivable-based financing could deteriorate.
WE ARE SUBJECT TO THE RISK THAT OUR INVENTORY VALUES MAY DECLINE AND PROTECTIVE
TERMS UNDER SUPPLIER AGREEMENTS MAY NOT ADEQUATELY COVER THE DECLINE IN VALUES.
Our business is subject to rapid technological change, new and enhanced
product specification requirements, and evolving industry standards. These
changes may cause inventory in stock to decline substantially in value or to
become obsolete. It is the policy of many suppliers to offer distributors like
us, who purchase directly from them, limited protection from the loss in value
of inventory due to technological change or such suppliers' price reductions.
For example, we can receive a credit from some suppliers for products, based
upon the terms and conditions with those suppliers, in the event of a supplier
price reduction. In addition, we have a limited right to return to some
suppliers a certain percentage of purchases. These policies are often not
embodied in written agreements and are subject to the discretion of the
suppliers. As a result, these policies do not protect us in all cases from
declines in inventory value. We offer no assurance that our price protection
will continue, that unforeseen new product developments will not materially
adversely affect us, or that we will successfully manage our existing and future
inventories.
During an economic downturn, it is possible that prices will decline due
to an oversupply of product, and therefore, there may be greater risk of
declines in inventory value. If major suppliers decrease the availability of
price protection to us, such a change in policy could lower our gross margins on
products we sell or cause us to record inventory write-downs. We expect the
restrictive supplier terms and conditions to continue for the foreseeable
future. We are also exposed to inventory risk to the extent that supplier
protections are not available on all products or quantities and are subject to
time restrictions. In addition, suppliers may become insolvent and unable to
fulfill their protection obligations to us.
FUTURE TERRORIST OR MILITARY ACTIONS COULD RESULT IN DISRUPTION TO OUR
OPERATIONS OR LOSS OF ASSETS, IN CERTAIN MARKETS OR GLOBALLY.
Future terrorist or military actions, in the U.S. or abroad, could result
in destruction or seizure of assets or suspension or disruption of our
operations. Additionally, such actions could affect the operations of our
suppliers or customers, resulting in loss of access to products, potential
losses on supplier programs, loss of business, higher losses on receivables or
inventory, and/or other disruptions in our business, which could negatively
affect our operating results. We do not carry broad insurance covering such
terrorist or military actions, and even if we were to seek such coverage, the
cost would likely be prohibitive.
13
FAILURE TO ATTRACT NEW SOURCES OF BUSINESS FROM EXPANSION OF PRODUCTS OR
SERVICES OR ENTRY INTO NEW MARKETS COULD NEGATIVELY IMPACT OUR FUTURE OPERATING
RESULTS.
Our business is subject to rapid technological change, new and enhanced
product specification requirements, and evolving industry standards. We continue
to look for new markets for products and services to keep up with changes in
demand and to respond to competition and other changes in the distribution
industry. Failure to successfully attract new sources of business could result
in loss of revenue in the future and negatively impact our operating results.
WE ARE DEPENDENT ON THIRD-PARTY SHIPPING COMPANIES FOR THE DELIVERY OF OUR
PRODUCTS.
We rely almost entirely on arrangements with third-party shipping
companies for the delivery of our products. The termination of our arrangements
with one or more of these third-party shipping companies, or the failure or
inability of one or more of these third-party shipping companies to deliver
products from suppliers to us or products from us to our reseller customers or
their end-user customers, could disrupt our business and harm our reputation and
net sales.
OUR STOCK PRICE HAS EXPERIENCED SIGNIFICANT VOLATILITY AND CONTINUED FLUCTUATION
COULD IMPAIR OUR ABILITY TO RAISE CAPITAL AND MAKE AN INVESTMENT IN OUR
SECURITIES UNDESIRABLE.
The stock markets have experienced price and volume fluctuations,
resulting in changes in the market prices of the stock of many companies, which
may not have been directly related to the operating performance of those
companies. In addition, the market price of our common stock has historically
fluctuated significantly. We believe factors such as indications of the market's
acceptance of our products and the performance of our business relative to
market expectations, as well as general volatility in the securities markets,
could cause the market price of our common stock to fluctuate substantially. Our
stock price has experienced significant volatility, and continued fluctuation
could impair our ability to raise capital and make an investment in our
securities undesirable.
THE EXERCISE OF OUTSTANDING WARRANTS AND OPTIONS MAY ADVERSELY AFFECT OUR STOCK
PRICE.
Our stock option plan authorizes the issuance of options to purchase
5,224,000 shares of our common stock. As of March 31, 2004, options and warrants
to purchase 4,091,664 shares of our common stock were outstanding. Many of these
options and warrants are currently exercisable. These options and warrants are
likely to be exercised at a time when the market price for our common stock is
higher than the exercise prices of the options and warrants. If holders of these
outstanding options and warrants sell the common stock received upon exercise,
it may have a negative effect on the market price of our common stock.
OUR ANTI-TAKEOVER PROVISIONS, RIGHT TO ISSUE PREFERRED STOCK AND OUR STAGGERED
BOARD MAY DISCOURAGE TAKEOVER ATTEMPTS THAT COULD BE BENEFICIAL FOR OUR
SHAREHOLDERS.
We are subject to Sections 302A.671 and 302A.673 of the Minnesota Business
Corporation Act, which may have the effect of limiting third parties from
acquiring significant amounts of our common stock without our approval. These
laws, among others, may have the effect of delaying, deferring or preventing a
third party from acquiring us or may serve as a barrier to shareholders seeking
to amend our Articles of Incorporation or Bylaws. Our Articles of Incorporation
also grant us the right to issue preferred stock which could allow us to delay
or block a third party from acquiring us. These shares of preferred stock could
also possess voting and conversion rights that could adversely affect the voting
power of the holders of the common stock. Finally, our Articles of Incorporation
and Bylaws divide our board of directors into three classes that serve staggered
three-year terms. Each of these factors could make it difficult for a third
party to effect a change in control of us. As a result, our shareholders may
lose opportunities to dispose of their shares at the higher prices typically
available in takeover attempts or that may be available under a merger proposal.
In addition, these measures may have the effect of permitting our current
directors to retain their positions and place them in a better position to
resist changes that our shareholders may wish to make if they are dissatisfied
with the conduct of our business.
* * * * * * * * * *
14
We operate a large business in a continually changing environment that
involves numerous risks and uncertainties. It is not reasonable for us to
itemize all of the factors that could affect us and/or the products and services
distribution industry as a whole. Future events that may not have been
anticipated or discussed here could adversely affect our business, financial
condition, results of operations or cash flows.
ITEM 2. PROPERTIES
On March 12, 1998, we entered into an operating lease agreement of
approximately 86,500 square feet of office and warehouse space for our principal
facilities in suburban Minneapolis. The lease agreement, as amended, expires in
June 2019 and provides for monthly payments of $40,712 over the lease term, with
a 2.5% increase every 30 months. In addition, we are responsible for taxes and
all operating costs associated with the building.
On April 22, 1999, we entered into an operating lease agreement of
approximately 74,000 square feet of office and warehouse space for a second
facility in suburban Minneapolis. The lease expires in September 2004 and
provides for a monthly rental of $35,473 over the lease term. In addition, we
are responsible for taxes and all operating costs associated with the building.
On March 30, 2000, we entered into an operating lease agreement of
approximately 40,000 square feet of warehouse space for a third facility in
suburban Minneapolis. The lease, which expires in March 2006, provides for a
monthly rental of $13,333 over the lease term. In addition, we are responsible
for taxes and all operating costs associated with the building.
On August 2, 2002, with the acquisition of Encore Software, Inc., we
acquired their operating lease of approximately 73,245 square feet of office and
warehouse space for their principal facilities in Gardena, California. The lease
expires in February 2005 and provides for a monthly rental of $40,438 over the
term of the lease. In addition, we are responsible for taxes and all operating
costs associated with the building.
On November 3, 2003, with the acquisition of BCI Eclipse Company LLC, we
acquired their operating lease of approximately 6,534 square feet of office
space for their principal facilities in Newbury Park, California. The lease
expires in March 2005 and provides for a monthly rental of $7,089 over the term
of the lease.
On May 27, 2004, we entered into an operating lease agreement of
approximately 115,286 square feet of office and warehouse space as an addition
to our principal facilities in suburban Minneapolis. The lease expires in June
2019 and provides for monthly payments of $57,939 over the lease term, with a
2.75% increase annually. In addition, we are responsible for taxes and all
operating costs associated with the building.
We believe that our facilities are adequate for our present operations for
the foreseeable future. We continually explore alternatives to certain of these
facilities that could expand our capacities and enhance efficiencies, but no
definitive agreements have been entered into in this regard.
ITEM 3. LEGAL PROCEEDINGS
In the normal course of our business, we are involved in a number of
routine litigation matters that are incidental to the operation of our business.
These matters generally include collection matters with regard to products
distributed by us and accounts receivable owed to us. We currently believe that
the resolution of any of these pending matters will not have a material adverse
effect on our financial position or results of operation. In addition, we are
subject to the litigation listed below.
BOB GRADY AND WILSON MEADOWS V. NAVARRE CORPORATION. ET. AL
On January 29, 2001, Bob Grady Music and Wilson Meadows (collectively,
"Plaintiffs") filed this action in the United States District Court for the
Northern District of Georgia, Case No. 01-CV-0252, alleging, among other things,
copyright infringement against the Company and seeking damages in excess of
$150,000 in connection with the Company's distribution of musical albums
pursuant to a written distribution agreement with Fortune Entertainment, Inc.
("Fortune"). On March 13, 2001, the Company answered the Complaint, denying
liability, and
15
asserting affirmative defenses. On March 13, 2001, the Company filed a
Third-Party Complaint against co-defendant Fortune and its owner Bruce Dugan,
seeking indemnity and contribution on the claims made by Bob Grady and Wilson
Meadows. Neither Fortune nor Bruce Dugan has responded to the Third Party
Complaint. Discovery is completed, and the parties filed cross-motions for
summary judgment.
On March 31, 2003, the District Court granted the Company's motion for
summary judgment, denied Plaintiffs' motion for summary judgment, and entered
judgment dismissing all of Plaintiffs' claims against the Company. The Company
moved for an award of its attorneys' fees on April 14, 2003, and Plaintiffs
responded, opposing the motion. By Order dated January 26, 2004, the District
Court granted in part and denied in part the Company's motion for an award of
attorneys' fees and ordered the Company to submit an itemized attorneys' fees
statement for purposes of entry of the award. The Company submitted the
attorneys' fees and expenses statement to the Court on February 6, 2004,
requesting $70,512.82.
Plaintiffs filed a Notice of Appeal with the Eleventh Circuit Court of
Appeals. However, Plaintiffs did not timely file their papers as required by
appellate rules of procedure, and the appeal was administratively dismissed on
August 25, 2003. Plaintiffs moved to re-open the appeal, the Company opposed the
motion, but on September 22, 2003, the Court granted the request and accepted
the late filed papers. The Company filed its responsive appeal brief on October
22, 2003. The Court heard oral arguments on March 11, 2004.
In an Opinion filed on June 21, 2004, the Court of Appeals affirmed in
part and vacated in part the District Court's grant of summary judgment to
Company, and remanded the case to the District Court for further proceedings.
The Court of Appeals affirmed the District Court's grant of summary judgment to
the Company on Plaintiffs' non-copyright infringement claims and on certain of
Plaintiffs' copyright infringement claims. However, the Court of Appeals
reversed the District Court's grant of summary judgment to the Company on
another of Plaintiffs' copyright infringement claims, and remanded the case to
the District Court for further proceedings on that claim.
Because of the contingencies and uncertainties associated with litigation,
it is difficult, if not impossible, to opine with respect to the exposure to the
Company, if any, at this juncture.
NAVARRE CORPORATION V. BROOKLYN MUSIC LTD., ET AL.
The Company commenced this action against Brooklyn Music Limited, Frank
Babar, and Joe Natoli. The Complaint was filed with the Hennepin County District
Court for the District of Minnesota on July 26, 2002, Brooklyn Music Ltd. was
served with the Company's Complaint on July 31, 2002, Frank Babar was served
with the Company's Complaint on July 31, 2002, and Joe Natoli was served with
the Company's Complaint on October 9, 2002. The Company alleges, among other
things, that the Defendants breached distribution and loan contracts with the
Company, and the Company seeks damages of at least $295,000.
As of November 15, 2002, all Defendants had answered the Company's
Complaint and asserted counterclaims. Defendants allege eleven separate
counterclaims based on breach of contract, gross negligence, willful misconduct,
and intentional bad faith, and seek damages which are difficult to decipher but
appear be at least $3,000,000, as well as nullification of the personal
guaranties of the individual defendants. The parties have completed discovery.
The Court issued an Amended Scheduling Order setting the case for trial during
the calendar trial block of January 5, 2004, but that date was continued
indefinitely because of a Court scheduling conflict. Mediation was completed,
but no settlement agreement was reached. Both sides moved for summary judgment
and the motions were heard on September 11, 2003.
By Order dated October 7, 2003, the Court granted in part, and denied in
part, the Company's motion, and denied entirely Defendants' motion for summary
judgment. Among other things, the Court granted the Company's motion against the
individual defendants/guarantors for the entire debt claimed by the Company (in
excess of $442,000), plus the Company's attorneys' fees and costs. The Court
also dismissed Counts 7, 8, and 9 of the individual Defendants' counterclaims.
Prior to the continuance of the January 5, 2004, trial date, the Company filed
various pretrial motions with the Court, including a motion for sanctions
against Defendants for failure to comply with the Court's pretrial order. The
Court has denied the motion for sanctions, but has reserved the pretrial motions
including motions to exclude certain portions of Defendants' evidence.
16
A jury trial commenced on May 24, 2004. During the course of the trial,
the parties settled the matter at nuisance value.
CLOUD TEN PICTURES, INC. V. NAVARRE CORPORATION
On or about April 2, 2003, Cloud Ten Pictures, Inc. ("Plaintiff")
commenced this action in Hennepin County District Court for the State of
Minnesota, by serving the Company with a Summons and Complaint, which Plaintiff
has now amended. Plaintiff alleges, among other things, accounting, breach of
contract, misrepresentation and negligent misrepresentation and seeks
unspecified damages. Plaintiff's claims are based upon Navarre's distribution of
two of Plaintiff's films. While discovery is on-going and the factual basis for
all of Plaintiff's claims has not yet been fully articulated by Plaintiff, it
appears that Plaintiff is claiming that, among other things, the Company took
credits on the account to which it was not entitled, failed to pay for allegedly
shipped product for which no invoice has been issued, and failed to properly
describe certain retail placement programs to Plaintiff. Plaintiff has not
specified in its Amended Complaint the damages it is seeking, but has demanded
in excess of $4 million.
The Company answered Plaintiff's Amended Complaint on March 29, 2004,
denying liability to Plaintiff and asserting various affirmative defenses. In
addition, the Company asserted its counterclaim against Plaintiff for breach of
contract and account stated and seeking damages in an amount of at least
$663,826.54. The Court heard the Company's motion for summary judgment on
January 30, 2004. By Order dated March 26, 2004, the Court granted the Company's
motion on the negligent misrepresentation claim, but denied the motion in all
other respects. Cloud Ten requested that the Court reconsider its ruling on the
negligent misrepresentation claim. The Company opposed the request, and the
Court denied the request for reconsideration. The parties participated in
mediation on May 3, 2004, but no settlement was reached. The parties continue to
discuss settlement. On June 14, the Court set the matter for trial during the
July 2004 block or the September 2004 block. Plaintiff has suggested it would
like to change the date for trial.
Because of the contingencies and uncertainties associated with litigation
of this kind, it is difficult, if not impossible, to opine with respect to the
exposure to the Company if any, at this juncture.
NAVARRE CORPORATION V. PROGRAM POWER ENTERTAINMENT
On or about August 1, 2003, the Company commenced an action against
Defendant Program Power Entertainment in Hennepin County District Court for the
State of Minnesota. The Company seeks damages in excess of $50,000 against
Program Power Entertainment, arising from Defendant's alleged breach of
financing agreements and a letter agreement intended to resolve disputes
surrounding a distribution agreement. The action has not been filed with the
Court.
On October 16, 2003, Defendant answered the Complaint, denying liability
to the Company and asserting a counterclaim for breach of contract related to
the distribution agreement. The Defendant seeks damages in excess of $50,000.
On November 5, 2003, the Company replied to the Counterclaim and denied
the material allegations thereof. The Company also asserted certain affirmative
defenses including, and without limitation, that the alleged contractual
breaches claimed by Defendant were settled by way of the letter agreement. No
further action has been taken by either party.
Because of the contingencies and uncertainties associated with litigation
of this kind, it is difficult, if not impossible, to opine with respect to the
exposure to the Company if any, at this juncture.
BLACK MARKET RECORDS, INC.
Black Market Records, Inc., is a debtor in a Chapter 7 bankruptcy
proceeding pending in the Eastern District of California, Sacramento Division
(Case No. 02-22348-B-7). On or about October 13, 2003, Black Market filed
pleadings in its bankruptcy case, identifying various claims against the
Company, including potential claims for infringement in connection with the
Company's distribution of certain musical recordings in which Black Market
claims an interest. Black Market seeks damages of "at least $100,000" in
connection with its claims against
17
the Company. The Company and Black Market have reached an agreement to settle
for $20,000, subject to bankruptcy court approval. We were recently advised that
bankruptcy approval of the settlement has been secured. We are in the process of
consummating the settlement.
AMERICAN GRAMAPHONE AND NAVARRE CORPORATION ARBITRATION
AMERICAN ARBITRATION ASSOCIATION, AAA FILE NO. 72 140 00263 04 SUBR.
On March 5, 2004, American Gramaphone commenced an arbitration proceeding
against the Company in California. Navarre has objected to the locale choice of
American Gramaphone and American Gramaphone has agreed that the arbitration
should occur in either Omaha, Nebraska or Minneapolis, Minnesota. The AAA has
not yet ruled on the locale issue. The arbitration dispute stems from the
Company's distribution of American Gramaphone, LLC products pursuant to a
written distribution agreement which has terminated. Since termination, the
Company and American Gramaphone, LLC have been attempting to reconcile the
various account balances between the parties. American Gramaphone, LLC has
notified the Company that it believes sums in excess of $250,000 are owed to it.
The Company disputes these claims.
On June 11, 2004, the parties reached an agreement to settle this matter,
in conjunction with the next matter listed, and the settlement documents are
being prepared by American Gramaphone's counsel.
AMERICAN GRAMAPHONE, ET AL. V. CLEOPATRA RECORDS AND NAVARRE
Plaintiffs, American Gramaphone, LLC, Dots and Lines Ink, and Louis F.
Davis, Jr. commenced this action by filing a Summons and Complaint with the
United States District Court, Central District of California, on December 8,
2003, Court File No. CV03-8913 JSL, against the Company and Cleopatra Records,
Inc. Plaintiffs allege trademark infringement, false designation of origin,
dilution, copyright infringement, California Statutory Unfair Competition,
California Common Law Unfair Competition, Accounting, and Constructive Trust, in
connection with the Company's distribution of "tribute albums" pursuant to its
distribution contract with Cleopatra Records. Plaintiffs seek injunctive relief
and statutory and related damages in an amount to be proven.
Plaintiffs moved for a temporary restraining order on December 8, 2003,
and by Order dated December 10, 2003, the Court granted the temporary
restraining order. Pursuant to the terms of the temporary restraining order, the
Company has, among other things, placed a "stop sell" on the subject albums and
issued a recall notice to retailers with respect to the tribute albums
distributed by the Company for its label, Cleopatra Records, Inc. The Company is
in the process of attempting to negotiate a compromise settlement of the matter.
The Company is looking to the label, Cleopatra Records, to cover the monetary
costs of any such settlement. On January 21, 2004, the Company served and filed
its Answer to Plaintiff's Complaint, denying liability and asserting applicable
affirmative defenses available under the law. On March 8, 2004, the Court
granted Plaintiff's motion for temporary injunction.
On June 11, 2004, the parties agreed to settle the matter, in conjunction
with the prior case, and the settlement documents are being prepared by
Plaintiff's counsel.
MICHAEL J. MATTHEWS D/B/A MJM MANAGEMENT V. NAVARRE CORPORATION, ET AL.
On January 2, 2004, Plaintiff commenced this action against the Company
and others by filing with the District Court of Harris County, Texas,
Plaintiff's Original Petition and Application for Temporary Restraining Order.
Plaintiff served the Company by mail on or about January 12, 2004. While the
Plaintiff alleges five causes of action, the only claim alleged against the
Company is for business disparagement in connection with the Company's
distribution of certain works of "Silk," which Plaintiff claims contained
information regarding the business manager of "Silk" which was defamatory as to
Plaintiff.
The Company filed a petition to remove the matter to the United States
District Court for the Southern District of Texas, Houston Division, on February
4, 2004, and filed a motion to dismiss Plaintiff's Complaint against the Company
with prejudice on the merits for failure to state a claim. Plaintiff's counsel
has indicated that Plaintiff intends to dismiss the claims against Navarre
voluntarily, but to date no such dismissal petition has been filed by Plaintiff.
The Court has not yet ruled on the Company's motion to dismiss.
18
Because of the contingencies and uncertainties associated with litigation
of this kind, it is difficult, if not impossible, to opine with respect to the
exposure to the Company if any, at this juncture.
DATA BECKER CORPORATION CLAIM
On April 5, 2004, the Company received correspondence from Stewart F.
Grossman, the Assignee for the Benefit of Creditors of Data Becker Corporation
("Data"). The Assignee asserts that the Company owes the Assignee $307,201.28 in
connection with the Company's distribution of Data's products. The Company has
asserted rights of setoff and recoupment arising from potential product returns.
At present, no suit has been commenced against the Company by the Assignee. The
Company and the Assignee are in the process of discussing their respective
positions.
Because of the contingencies and uncertainties associated with litigation
of this kind, it is difficult, if not impossible, to opine with respect to the
exposure to the Company if any, at this juncture.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
three-month period ended March 31, 2004.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
PRICE RANGE OF COMMON STOCK
Our Common Stock has been quoted on The NASDAQ Stock Market under the
symbol NAVR. The following table presents the range of high and low closing sale
prices for our stock for each period indicated as reported on The NASDAQ Stock
Market. Such prices reflect inter-dealer prices, do not include adjustments for
retail mark-ups, markdowns or commissions and may not necessarily represent
actual transactions.
QUARTER HIGH LOW
----------------------------------------
Fiscal 2004 First $ 2.37 $ 1.67
Second 3.00 1.96
Third 7.13 2.74
Fourth 7.44 5.85
Fiscal 2003 First $ 1.80 $ 1.11
Second 1.67 1.20
Third 2.66 1.02
Fourth 2.40 1.52
HOLDERS AND DIVIDENDS
At June 15, 2004, we had 703 common shareholders of record and an
estimated 9,800 beneficial owners whose shares were held by nominees or broker
dealers. We have never paid any dividends on our common stock and do not intend
to pay any dividends on our common stock in the foreseeable future.
EQUITY COMPENSATION PLAN INFORMATION
We adopted our 1992 Stock Option Plan to attract and retain persons to
perform services for us by providing an incentive to these persons through
equity participation in the Company and by rewarding such persons who contribute
to the achievement of our economic objectives. Eligible recipients are all
employees including, without limitation, officers and directors who are also our
employees as well as our non-employee directors, consultants and independent
contractors or of any of our subsidiaries. A maximum number of 5,224,000 shares
of common stock have been authorized and reserved for issuance under the Plan.
The number of shares authorized
19
may also be increased from time to time by approval of the Board and the
shareholders. The Plan terminates on July 1, 2006.
We are authorized to grant stock options and restricted stock grants under
the Plan. Options generally vest in increments of 20% of the original option
grant beginning one year from the date of grant and expire six years from the
date of grant, subject to early termination upon death, disability or
termination of employment. Performance-based options are subject to variable
accounting and will be recognized when, and if, the criteria are met for
vesting.
On April 1 of each year, each director who is not an employee of Navarre
is granted an option to purchase 6,000 shares of common stock under the Plan, at
a price equal to fair market value. These options are designated as
non-qualified stock options and are subject to the same terms and provisions as
are then in effect with respect to granting of non-qualified stock options to
salaried officers and key employees of Navarre. These options vest in increments
of 20% of the original option grant beginning one year from the date of grant
and expire six years from the date of grant.
We are entitled to (a) withhold and deduct from future wages of the
participant (or from other amounts that may be due and owing to the participant
from us), or make other arrangements for the collection of, all legally required
amounts necessary to satisfy any and all federal, state and local withholding
and employment-related tax requirements (i) attributable to the grant or
exercise of an option or a restricted stock award or to a disqualifying
disposition of stock received upon exercise of an incentive stock option, or
(ii) otherwise incurred with respect to an option or a restricted stock award,
or (iii) require the participant promptly to remit the amount of such
withholding to us before taking any action with respect to an option or a
restricted stock award.
The following table below presents our Equity Compensation Plan
information:
Number of securities
remaining available for future
Plan Category Number of securities to be issuance under equity
issued upon exercise of Weighted-average exercise compensation plans
outstanding options, price of outstanding options, (excluding securities
warrants and rights warrants and rights reflected in column (a))
(a) (b) (c)
Equity compensation plans
approved by security holders 2,927,200 $3.41 357,154
Equity compensation plans
not approved by security
holders -0- -0- -0-
========= ===== =======
Total 2,927,200 $3.41 357,154
========= ===== =======
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data should be read in conjunction with
our financial statements and related notes, "Management's Discussion and
Analysis of Financial Condition and Results of Operations," and other financial
information appearing elsewhere in this annual report on Form 10-K. We derived
the following historical financial information from the consolidated financial
statements of Navarre for the fiscal years ended March 31, 2004, 2003, 2002,
2001 and 2000 which have been audited by Ernst & Young LLP.
20
(In thousands, except per share data)
FISCAL YEARS ENDED MARCH 31,
2004 2003 2002 2001 2000
---- ---- ---- ---- ----
STATEMENT OF OPERATIONS DATA:
Net sales $ 475,244 $ 359,384 $ 303,817 $ 314,199 $ 285,165
Gross profit, exclusive of
amortization and depreciation 57,340 45,013 32,893 37,421 36,381
Income (loss) from operations 9,147 4,005 521 (2,364) (4,554)
Interest expense (378) (194) (173) (223) (476)
Other income (expense) (456) 447 884 2,000 1,399
Net income (loss) before tax 8,313 4,321 2,712 (10,925) (7,785)
Tax benefit 583 ---- ---- ---- ----
Net income (loss) $ 8,896 $ 4,321 $ 2,712 $ (10,925) $ (7,785)
Income (loss) per basic share $ .39 $ .20 $ .12 $ (.47) $ (.33)
Income (loss) per diluted share $ .37 $ .20 $ .12 $ (.47) $ (.33)
Basic weighted average common
shares outstanding 22,780 21,616 22,553 25,137 23,483
Diluted weighted average common
shares outstanding 24,112 21,841 22,575 25,137 23,483
BALANCE SHEET DATA:
Total assets $ 146,927 $ 101,129 $ 81,085 $ 93,918 $ 109,711
Short-term borrowings 651 805 ---- ---- ----
Long-term debt ---- 268 ---- ---- ----
Shareholders' equity 55,568 28,671 24,350 24,350 41,423
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
EXECUTIVE SUMMARY
Fiscal 2004 was a year of growth for Navarre Corporation. Our consolidated
net sales for fiscal 2004 increased 32% to $475.2 million compared to $359.4
million in fiscal 2003. This growth was achieved through increases in all of our
product groups. Our gross profit increased to $57.3 million or 12.1% of net
sales compared with $45.0 million or 12.5 % of net sales for fiscal 2003. The
main cause of the decrease as a percent of net sales for fiscal 2004 was due to
a $5.6 million impairment charge for the capitalized product development costs
associated with the Dare Devil video game. Total operating expenses for fiscal
2004 were $48.2 million or 10.1% of net sales, compared with $41.0 million or
11.4% of net sales for fiscal 2003. We incurred a slight increase in expenses
during fiscal 2004 due to the addition of BCI Eclipse in November 2003 as well
as $705,000 in charges related to stock-based compensation. Net income increased
to $8.9 million or $0.37 per diluted share compared to $4.3 million or $0.20 per
diluted share for last year.
We acquired the assets of BCI Eclipse in November 2003. This acquisition
strengthened our Publishing business with a provider of niche DVD/video
products. We expect this segment to grow substantially during fiscal 2005 with
the addition of business generated through our five-year exclusive agreement to
distribute Riverdeep products as announced in April 2004. In December 2003, we
completed a private placement in public equity financing ("PIPE") that netted
$11,735,000 from the sale of 2,631,547 shares of common stock with 657,887 five
year stock purchase warrants exercisable at $7.00 per share. The Company used
the net proceeds to pay off acquisition debt incurred to purchase BCI Eclipse
and the remainder was made available for, among other things, general working
capital needs.
21
OVERVIEW
Navarre Corporation, a Minnesota corporation formed in 1983, publishes and
distributes a broad range of home entertainment and multimedia products,
including PC software, audio and video titles and interactive games. Our
business is divided into two business segments -- Distribution and Publishing.
Through these business segments we maintain and leverage strong relationships
throughout the publishing and distribution chain.
Our broad base of customers includes: (i) wholesale clubs, (ii) mass
merchandisers, (iii) other third-party distributors, (iv) computer specialty
stores, (v) music specialty stores, (vi) book stores, (vii) office superstores,
and (viii) electronic superstores. Our customer base includes over 500
individual customers with over 18,000 locations, certain of which are
international locations.
Through our Distribution business we distribute and provide fulfillment
services in connection with a variety of finished goods that are provided by our
vendors, which include a variety of publishers, independent and major music
labels, and movie studios. These vendors provide us with PC software, CD and DVD
audio, DVD and VHS video, video games and accessories. Our Distribution business
focuses on providing retailers and publishers with high-quality services for the
broad, efficient distribution of these products, including vendor-managed
inventory, Electronic Data Interchange services, fulfillment services, and
retailer-oriented marketing services.
Through our Publishing business we are the exclusive licensee or owner of
PC software, CD and DVD audio, DVD and VHS video, and video game titles. Our
Publishing business licenses, packages, markets and sells these products to
third-party distributors, directly to retailers, as well as to Navarre's
Distribution business.
Much of our growth in the Publishing segment over the last two fiscal
years was accomplished by acquisition. In July 2002, we purchased the primary
assets of Encore Software, Inc., a publisher of entertainment and education PC
products. In November 2003 we purchased the primary assets of BCI Eclipse, Inc.,
a provider of niche DVD/video products. In addition, In April 2004, we signed an
exclusive five-year co-distribution agreement with Riverdeep that we expect will
significantly increase this segment's revenues and profits. This rapid growth
(and expected growth) may make this segment's results in future periods more
uncertain and less predictable.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in conformity with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and assumptions that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. On an on-going basis, we review and evaluate our estimates,
including those related to customer programs and incentives, product returns,
bad debt, inventories, investments, intangible assets, restructuring reserves
and litigation. We base our estimates on historical experience and various other
assumptions that are believed to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities that are not readily apparent from other sources.
Actual results could differ from these estimates under different assumptions or
conditions.
We believe the following critical accounting policies are affected by our
judgment, estimates and/or assumptions used in the preparation of our
consolidated financial statements.
Revenue Recognition
The Company recognizes revenue at the time product is received by our
customers and title has passed, and provides a reserve for sales returns based
on the trailing twelve months' experience by product line. These assumptions
have been reasonably accurate, resulting in a sales return reserve accuracy of
approximately 99% of actual sales returns in each of the past three years. Our
actual sales return rates average between 14 to 20% over the past three years.
The Company's selling price is fixed at the time of shipment and invoicing. The
terms of our sales agreements are not contingent upon the resale of the product
by our customers, and we have no continuing obligation to our customers.
22
The Company's distribution customers at times qualify for certain price
protection benefits from the Company's vendors. The Company serves as an
intermediary to settle these amounts between vendors and customers. The Company
accounts for these amounts as reductions of revenues with corresponding
reductions in cost of goods sold in the period of the initial sale to customers.
The Company does at times provide certain price protection, promotional
monies, back-end volume rebates and other incentives to customers in its
publishing business. The Company records reserves for these incentives based on
trailing twelve months' experience rates by product line. The Company records
these amounts as reductions in revenue at the time the original revenue is
recorded.
Although our past experience has been a good indicator of future return
levels and other revenue reductions, there can be no assurance that our current
reserve levels will be adequate in the future.
Allowance for Doubtful Accounts
The Company performs periodic credit evaluations of its customers'
financial condition and generally does not require collateral. Receivables
generally are due within sixty days. We evaluate the collectibility of our
accounts receivable, including advances and balances with independent labels,
based on a combination of factors. In circumstances where we are aware of a
specific customer's inability to meet their financial obligations to us (e.g.,
bankruptcy filings, substantial down-grading of credit scores), we record a
specific reserve for bad debts against amounts due to reduce the net recognized
receivable to the amounts we reasonably believe will be collected. For all other
customers, we recognize reserves for bad debts based on the length of time the
receivables are past due based on our historical experience of write-offs of
accounts with similar characteristics. Our largest collection risks exist for
retail customers that are in bankruptcy, or at risk of bankruptcy. The
occurrence of these events is infrequent, but can be material when it does
occur. For instance, although our overall rate of uncollectible sales over the
past three years has been approximately .4% of sales, the largest amounts
resulted from the bankruptcy of Pacific Coast One Stop, Inc. and Valley Media,
Inc., which resulted in write-offs of approximately $2.6 million. Although
credit losses relating to customers consistently have been within management's
expectations, if circumstances change (i.e., higher than expected defaults or an
unexpected material adverse change in a major customer's ability to meet its
financial obligations to us), our estimates of the recoverability of amounts due
could be reduced by a material amount.
Goodwill Impairment
We review goodwill for potential impairment annually for each reporting
unit and when events or changes in circumstances indicate the carrying value of
the goodwill might exceed its current fair value. We have no goodwill associated
with our Distribution segment, while our Publishing segment has two reporting
units that have goodwill - Encore and BCI Eclipse. We determine fair value using
widely accepted valuation techniques, including discounted cash flow and market
multiple analysis. These types of analyses require us to make certain
assumptions and estimates regarding industry economic factors and the
profitability of future business strategies. It is our policy to conduct
impairment testing once annually based on our most current business strategy in
light of present industry and economic conditions, as well as future
expectations. The Company's goodwill of $10.4 million as of March 31, 2004
consists of $3.1 million associated with our acquisition of Encore, and $7.3
million associated with our acquisition of BCI Eclipse LLC. Prior to a $5.6
million impairment charge for the capitalized product development costs
associated with the Dare Devil video game, Encore provided approximately $2.0
million of operating profit during the year ended March 31, 2004, while BCI
Eclipse provided approximately $1.7 million of operating profit since we
acquired it on November 3, 2003. If the operating results for Encore and BCI
Eclipse deteriorate considerably and are not consistent with our assumptions and
estimates, we may be exposed to a goodwill impairment charge that could be
material.
Cost Associated with Exit Activities
We adopted SFAS No. 146, Accounting for Costs Associated with Exit or
Disposal Activities on January 1, 2003. Since adoption, the present value of
costs associated with location closings, primarily future lease costs, real
estate taxes and common area maintenance, are charged to earnings when a
location is vacated. When applicable, the liability is reduced by estimated
future sublease income. Prior to our adoption of SFAS No. 146, a liability for
location closings was recognized when management made the commitment to relocate
or close the location.
23
Tax Matters
Income taxes are recorded under the liability method. Deferred income
taxes are provided for temporary differences between the financial reporting and
tax bases of assets and liabilities. Deferred tax assets are reduced by
valuation allowances if it is more likely than not that some portion of the
asset will not be realized. The Company's net deferred income tax assets were
completely reserved for fiscal 2002 and 2003 because of its recent history of
pre-tax losses. Reversals of these valuation reserves during fiscal 2002, 2003,
and 2004 have resulted in the recording of tax benefits associated with its
utilization of net operating loss carryforwards. In addition to recognizing tax
benefits related to utilization of net operating loss carryforwards in fiscal
2004, the Company has also recognized an additional $1.0 million of tax benefit
related to the reversal of a like amount of valuation reserve. Such amount of
valuation reserve reversal was made due to the increasing probability of its
ability to generate near-term pre-tax income. We continue to maintain a
valuation allowance on the majority of our remaining net operating loss carry
forwards, and it is possible that our fiscal 2005 results could include the
reversal of additional amounts of tax valuation reserves, which will be recorded
as a reduction of income tax expense to the extent that our taxable income
exceeds certain levels.
Capitalized Software Development Costs
Software costs incurred subsequent to the determination of the
technological feasibility of software products are capitalized. Capitalization
ceases and amortization of costs begin when the software product is available
for general release to customers or shipment has begun. The Company tests for
possible impairment whenever events or changes in circumstances, such as a
reduction in expected cash flows indicating that the carrying amount of the
asset may not be recoverable. If indicators exist, the Company compares the
undiscounted cash flows related to the asset to the carrying value of the asset.
If the carrying value is greater than the undiscounted cash flow amount, an
impairment charge is recorded in cost of goods sold in the statement of
operations for amounts necessary to reduce value of the asset to fair value. The
Company has recorded an impairment charge associated with product development
costs in fiscal 2004 of $5.6 million. The Publishing segment subsequently closed
product development activities so no such charges are expected to occur in the
future.
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated the percentage of
net sales represented by certain items included in our "Consolidated Statements
of Operations."
FISCAL YEARS ENDED MARCH 31,
2004 2003 2002
------- ------- -------
Net sales:
Distribution 94.5% 99.0% 100.0%
Publishing 9.7 4.1 ----
Elimination of sales (4.2) (3.1) ----
------- ------- -------
Total net sales 100.0 100.0 100.0
Cost of sales 87.9 87.5 89.2
------- ------- -------
Gross profit, exclusive of
amortization and depreciation 12.1 12.5 10.8
Selling and marketing 3.4 3.7 2.7
Distribution and warehousing 1.3 1.5 1.7
General and administrative 4.9 5.6 5.6
Depreciation and amortization 0.4 0.6 0.5
Restructuring ---- ---- 0.2
Stock-based compensation 0.2 ---- ----
------- ------- -------
Total operating expenses 10.2 11.4 10.7
------- ------- -------
Income from operations 1.9 1.1 0.2
Debt extinguishment (0.2) ---- ----
Interest expense (0.1) (0.1) (0.1)
24
Other income 0.1 0.2 0.8
Tax benefit 0.2 ---- ----
--- ---- -----
Net income 1.9 1.2 0.9
=== ==== =====
Certain information in this section contains forward-looking statements.
Our actual results could differ materially from the statements contained in the
forward-looking statements as a result of a number of factors, including risks
and uncertainties inherent in our business, dependency upon key employees, the
seasonality of our business, dependency upon significant customers and vendors,
erosions in our gross profit margins, dependency upon bank borrowings, obtaining
additional financing when required, dependency upon software developers and
manufacturers, dependency upon recording artists, risks of returns and inventory
obsolescence, effect of technology developments, effect of free music downloads,
change in retailers methods of distribution and the possible volatility of our
stock price. See "Business - Forward-Looking Statements / Important Risk
Factors" in Item 1 of the Form 10-K.
DISTRIBUTION SEGMENT
The Distribution segment distributes software, video games, accessories,
major label music, and DVD video, as well as independent music.
Fiscal 2004 Results Compared With Fiscal 2003
Net Sales
Net sales for the Distribution segment were $449.1 million for fiscal 2004
compared to $355.9 million for fiscal 2003. The 26% increase in net sales for
fiscal 2004 was principally due to strong increases in sales across all of our
distribution product groups. In particular, software continues to expand its
market share presence across all categories. Internet security and anti-virus
products remained strong in light of continued virus outbreaks. Sales increased
in this product group to $317.8 million during fiscal 2004. Major label music,
DVD video and Video Games grew to $74.4 million in fiscal 2004 due to the
combinations of increased publisher and customer rosters and benefited from
strong releases throughout the year. Independent music also grew to $56.0
million in fiscal 2004 due to its increased label and artist roster and its
continued focus on catalog across all music genres. Future sales increases will
be dependent upon the Company's ability to continue to add new, appealing
content.
Gross Profit
Gross profit for the Distribution segment was $48.1 million or 10.7% as a
percent of net sales for fiscal 2004 compared to $39.2 million or 11.0% as a
percent of net sales for fiscal 2003. The decrease in gross profit as a percent
of net sales for fiscal 2004 was due to lower margins from the growth of our
video game distribution business. Video game distribution generally has a lower
margin throughout the industry, however, video games are sold on a one-way basis
with no returns by the customer allowed; therefore, the lower handling costs of
the product offset some of the lower margins as it relates to profitability. In
addition, we experienced lower margins with the continuation of the expansion of
our market share in software categories such as business and productivity which
generally have lower gross margins as much of the product is considered legacy
product; however, these product categories tend to sell at higher dollar price
points and generally have fewer returns. We expect gross profit to fluctuate
slightly depending upon the make-up of product sales each quarter as the Company
continues to expand its market share in business and productivity software and
video games. We experienced higher margins from sales of independent music in
fiscal 2004 due to our continuing efforts to sign new labels at higher
distribution rates. We would expect this trend to continue as we continue to
focus on high quality labels that provide higher overall margins. To the extent
the Company continues to grow its share of legacy products from large vendors at
a rate faster than certain entertainment products from the smaller vendors, we
would expect a slightly overall margin decrease in future years.
The Company expects gross margins to increase as our Publishing business
grows to become a larger share of our overall business. Publishing margins are
in the 38 to 42% range compared to Distribution margins which are in the 11 to
13% range.
25
Operating Expenses
Total operating expenses for the Distribution segment were $37.0 million
or 8.2 % as a percent of net sales for fiscal 2004 compared to $35.2 million or
9.9% as a percent of net sales for fiscal 2003.
Selling and marketing expenses for the Distribution segment were $9.8
million or 2.2% as a percent of net sales for fiscal 2004 compared to $10.7
million or 3.0% as a percent of net sales for fiscal 2003. The decrease for
fiscal 2004 resulted from our improved efforts to reduce freight costs. Freight
cost, as a percent of sales, decreased to 1.4% in fiscal 2004 compared to 1.8%
in fiscal 2003. Additionally, we recorded an expense of $680,000 in fiscal 2003
in connection with the write-off of specialty product display sales racks. The
Company manages these expenses on a percentage basis and would expect to remain
in the 2.7-3.0% of net sales range.
Distribution and warehousing expenses for the Distribution segment were
$6.0 million or 1.3% as a percent of net sales for fiscal 2004 compared to $5.5
million or 1.5% as a percent of net sales for fiscal 2003. The decrease as a
percentage of net sales resulted from overall improved efficiency of warehousing
expenses such as "one way" video game business, higher priced software
categories such as business and productivity, and in part, efficiencies
associated with a higher level of sales. The Company will continue to seek
efficiencies in this area, but will continue to manage expenses at approximately
1.5% of net sales.
General and administrative expenses for the Distribution segment consist
principally of executive, accounting and administrative personnel and related
expenses, including professional fees. General and administrative expenses for
the Distribution segment were $19.2 million or 4.3% as a percent of net sales
for fiscal 2004 compared to $17.8 million or 5.0% as a percent of net sales for
fiscal 2003. The increase in general and administrative expenses for fiscal 2004
resulted from an increase in IT expense of $476,000 which is based on sales
volume, and $891,000 for executive, accounting and administrative personnel
required as our business grows. The decrease as a percent of net sales for
general and administrative expenses for fiscal 2004 was attributable to our
continued increased efforts to control expenses as a percent of net sales. While
overall general and administrative expenses are expected to increase, we feel
that the increase will be at a rate less than our sales growth rate, thus
allowing us to leverage our existing infrastructure. We expect that expenses
will continue to be managed in a 4.8-5.2% range.
Depreciation and amortization for the Distribution segment remained flat
at $1.3 million for fiscal 2004 and for fiscal 2003.
During fiscal 2004, we recorded a non-cash charge of $705,000 for
stock-based compensation relating to the vesting of option shares exercisable
under option agreements for certain key employees.
The net operating income for the Distribution segment was $11.0 million
for fiscal 2004 compared to $4.0 million for fiscal 2003.
Fiscal 2003 Results Compared With Fiscal 2002
Net Sales
Net sales for the Distribution segment were $355.9 million for fiscal 2003
compared to $303.8 million for fiscal 2002. The 17% increase in net sales for
fiscal 2003 was due to the continued increase in our market share across all
categories of the software industry, particularly with additions to our
publisher roster of business and productivity product lines. Sales of
independent music increased due to the addition of new content that broadened
our reach across all musical genres and our rich offering of catalog titles that
continues to lessen our reliance on new releases.
Gross Profit
Gross profit for the Distribution segment was $39.2 million or 11.0% as a
percent of net sales for fiscal 2003 compared to $32.9 million or 10.8% as a
percent of net sales for fiscal 2002. The increase in gross profit and as a
percent of net sales for fiscal 2003 was attributable to higher margins on sales
of independent music from new
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labels with higher distribution rates but on the other hand software categories
such as business and productivity experienced lower margins.
Operating Expenses
Total operating expenses for the Distribution segment was $35.2 million or
9.9% as a percent of net sales for fiscal 2003 compared to $32.4 million or
10.7% as a percent of net sales for fiscal 2002.
Selling and marketing expenses for the Distribution segment was $10.7
million or 3.0% as a percent of net sales for fiscal 2003 compared to $8.1
million or 2.7% as a percent of net sales for fiscal 2002. The increase in
fiscal 2003 included an expense item of $680,000 resulting from our purchase of
specialty product display sales racks for a distribution method that failed to
achieve expected results. The decrease in selling and marketing expenses and as
a percent of net sales for fiscal 2002 was due to the lower costs associated
with improved management of and communication with our vendors to reduce the
need for expedited freight.
Distribution and warehousing expenses for the Distribution segment was
$5.5 million or 1.5% as a percent of net sales for fiscal 2003 compared to $5.2
million or 1.7% as a percent of net sales for fiscal 2002. The decrease as a
percent of net sales was the effect of overall increased efficiencies as we
continue to find ways to lower the overall expenses.
General and administrative expenses for the Distribution segment consist
principally of executive, accounting and administrative personnel and related
expenses, including professional fees. General and administrative expenses for
the Distribution segment was $17.8 million or 5.0% as a percent of net sales for
fiscal 2003 compared to $16.9 million or 5.6% as a percent of net sales for
fiscal 2002. The decrease as a percent of net sales for general and
administration expenses for fiscal 2003 was attributable to continued increased
efforts to control expenses.
Depreciation and amortization expense for the Distribution segment was
$1.3 million in fiscal 2003 compared to $1.5 million in fiscal 2002. Included in
fiscal 2002 was a charge of $356,000 associated with the relocation of the
Hawaiian location.
The net operating income for the Distribution segment was $4.0 million for
fiscal 2003 compared to $521,000 for fiscal 2002.
PUBLISHING SEGMENT
The Publishing segment includes Encore Software and BCI Eclipse. We
acquired the assets of BCI Eclipse, LLC on November 3, 2003 and the assets of
Encore Software, Inc. on July 31, 2002. No comparison of operations is included
herein for fiscal 2003 to fiscal 2002 as we had no operations in this segment in
fiscal 2002.
Fiscal 2004 Results Compared With Fiscal 2003
Net sales for the Publishing segment were $46.2 million (before
inter-company sales elimination of $20.0 million) for fiscal 2004 and $14.7
million (before inter-company sales elimination of $11.2 million) for fiscal
2003. $8.0 million of the growth was due to the addition of the BCI Eclipse
business in November 2003.
Gross profit for the Publishing segment was $9.3 million or 35.6% as a
percent of net sales for fiscal 2004 and $5.8 million or 39.4% as a percent of
net sales for fiscal 2003. The gross margin decrease was due to a $5.6 million
impairment charge for the capitalized product development costs associated with
the Dare Devil video game. The Publishing segment subsequently ceased product
development activities.
Operating expenses for the Publishing segment were $11.1 million for
fiscal 2004, including $5.7 million for sales and marketing expenses, $752,000
for licensing and development expenses, $4.0 million for general and
administration expenses and $673,000 for depreciation and amortization expense.
For fiscal 2003, operating expenses were $5.8 million, including $2.2 million
for sales and marketing expenses, $468,000 for licensing and development
expenses, $2.3 million for general and administration expenses and $822,000 for
depreciation and amortization expense, which included a charge of $501,000 for
certain intangible assets that were deemed impaired
27
subsequent to the acquisition of Encore. The expense increase in fiscal 2004 was
due to the addition of BCI in November 2003.
The Publishing segment had an operating loss of $1.9 million for fiscal
2004 and operating income of $41,000 for fiscal 2003.
We expect significant growth in this segment with the inclusion of BCI
Eclipse results of operations for a full year and with the addition of
approximately $45-$55 million in revenues expected to be generated from
distribution of Riverdeep products during fiscal 2005.
CONSOLIDATED OTHER INCOME AND EXPENSE
Interest expense was $378,000 for fiscal 2004, $194,000 for fiscal 2003,
and $173,000 for fiscal 2002. The increase in interest expense for fiscal 2004
resulted from our use of our line of credit and the Hilco mezzanine financing
incurred in connection with the acquisition of BCI. The increase in interest
expense for fiscal 2003 was primarily due to having a credit facility in place
for the full year. Other income, which consists principally of interest income
on available cash balances, was $452,000 for fiscal 2004, $447,000 for fiscal
2003, and $884,000 for fiscal 2002. Lower interest rates resulted in the
decrease for fiscal 2003.
During the third quarter of fiscal 2004, we recorded a non-recurring
charge incurred in connection with the complete discharge of the Hilco financing
used for the BCI Eclipse acquisition of $908,000, consisting of deferred debt
acquisition fees of $536,000 and the fair value of the warrants issued to the
lender of $372,000.
Subsequent to November 5, 1999, we owned an equity position in NetRadio
that constituted less than 50% of the outstanding equity interests in this
company. Accordingly, NetRadio results for fiscal 2003 and 2002 are reflected in
our financial statements using the equity method. Under the equity method,
Navarre reported losses or income in NetRadio for each period as "Impact of
investment in NetRadio Corporation." The impact of the investment in NetRadio
Corporation was income of $63,000 for fiscal 2003 and income of $1.5 million for
fiscal 2002. This entity was dissolved on January 15, 2003.
We recorded a tax net benefit of $583,000 for fiscal 2004. We utilized
existing net operating loss carry forwards in fiscal 2004. Because these net
operating loss carryforwards had been completely reserved, we incurred no
federal income tax expense on the majority of our earnings. As of March 31,
2004, we have approximately $10.9 million of net operating losses remaining. We
also reversed an additional $1.0 million of our deferred tax asset valuation
reserve in the fourth quarter of f