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FORM 10-K
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended SEPTEMBER 27, 2003
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______ to ______
Commission file No. 0-15338
PHOTOWORKS, INC.
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(Exact name of registrant as specified in its charter)
Washington 91-0964899
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(State or other jurisdiction of incorporation or organization) (IRS Employer Identification No.)
1260 16th Avenue West, Seattle, WA 98119
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (206) 281-1390
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Securities registered pursuant to Section 12(b) of the Act: None
----
Securities registered pursuant to Section 12(g) of the Act: Common Stock, par
value $.01 per share and related preferred share purchase rights.
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 the
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 filed (as
defined in Rule 12b-2 of the Exchange Act). Yes: |_| No: |X|
As of March 29, 2003 the aggregate market value of the Registrant's Common
Stock held by non-affiliates of the Registrant was $2,462,971 based on the last
sale price of the Registrant's Common Stock as reported by the Over the Counter
Bulletin Board Market.
As of December 5, 2003, there were issued and outstanding 16,682,285
shares of Common Stock, par value $.01 per share.
Documents incorporated by reference:
Portions of the registrant's definitive Proxy Statement to be delivered to
shareholders in connection with the Annual Meeting of Shareholders, to be held
on February 3, 2004, are incorporated by reference into Part III.
1
Exhibit Index at Page 46
PART I
ITEM 1 - BUSINESS
Description of Business
PHOTOWORKS, INC: ("PhotoWorks" or the "Company") is a leading photo
services company, dedicated to providing our customers with innovative ways to
enjoy and use their photos through online and mail-order channels. PhotoWorks
offers processing and printing services to both traditional and digital camera
users, primarily in the United States, providing customers with the ability to
store and organize photos online, share them with friends and family, and order
prints, reprints, photo albums, and photo related products.
PhotoWorks draws upon a unique dual heritage as a top-rated photofinisher
with over twenty-five years of experience along with a tradition of innovation
and leadership in digital and online photo services. We provide digital camera
owners with easy ways to get professional quality digital prints in addition to
providing online image storage and management services. PhotoWorks can also
process any brand of 35mm film, Advanced Photo Systems (24mm) film or 35mm
single-use cameras, and offers prints, slides, digital images and online
archiving, all from the same roll of 35mm film.
PhotoWorks was incorporated in Washington State in June 1976. The
executive offices are located at 1260 Sixteenth Avenue West, Seattle, Washington
98119, and the telephone number is (206) 281-1390. References to PhotoWorks and
the Company in this Report include PhotoWorks, Inc., and its wholly-owned
subsidiaries.
Forward-Looking Information
This report contains forward-looking statements including, without
limitation, statements identified by an asterisk (*). These statements relate to
future events, product or service offerings or the future financial performance
of the Company. In some cases, you can identify forward-looking statements by
terminology such as "may," "will," "should," "expects," "plans," "anticipates,"
"believes," "estimates," "predicts," "potential," or "continue" or the negative
of such terms and other comparable terminology. These statements only reflect
expectations and estimates of the Company's management. Actual events or results
may differ materially from those expressed or implied by such forward-looking
statements. Relevant risks and uncertainties include, among others, those
discussed in Item 1 of Part 1 under the heading "Risk Factors" and elsewhere in
this report and those described from time to time in the Company's other filings
with the Securities and Exchange Commission, press releases and other
communications. All forward-looking statements contained in this report reflect
PhotoWorks' expectations at the time of this report only, and the Company
disclaims any responsibility to revise or update any such forward-looking
statement except as may be required by law.
Industry Overview
The dominant method of distributing photofinishing services and products
is through retail stores, including discount and mass merchants, drugstores,
supermarkets and camera/specialty stores. The majority of prints are processed
through wholesale photofinishing laboratories or processed in-store using
on-site equipment.
Digital cameras are becoming more mainstream as quality increases and
price decreases. In 2003, sales of digital cameras surpassed sales of
traditional cameras. We believe that we can serve consumers using digital
cameras by offering professional quality digital prints and innovative products
through convenient online services.* Digital cameras and the Internet are
creating new opportunities for people to use and share their photos.
2
Operating Strategy
The principal elements of our operating strategy are the introduction of
innovative, convenient and easy to use digital services and products and a
commitment to service and customer satisfaction. We will continue to emphasize
excellent service, professional quality, value, and convenience rather than try
to be a low-price or rapid turnaround provider.
Digital Services and Products. We believe that PhotoWorks can distinguish
itself from its online and traditional photofinishing competitors through
value-added digital services and product differentiation. We believe that our
complementary value-added services and products promote customer loyalty and
increase customer demand.* We also believe that our online archive of customer
images is a viable and economic opportunity to monetize a customer's "personal
equity" by providing image storage and management services for digital and film
based camera users and through photo output, in the form of digital prints,
reprints and gifts. Our commitment to ease of use and expanded service and
product offerings, is intended to support this strategy.*
Over the years, we have been a leader in providing digital-imaging
technologies. Some products incorporating these technologies include (i)
PhotoDVD(TM) and PhotoVHS, an animated show of personal photos on DVD or VHS;
(ii) Pictures On Disk(TM) on CD, a CD containing digital images from a roll of
film or digital camera; and, (iii) our online image management system which
gives customers a simple and convenient way to buy prints and view, share, and
organize their photos online. We plan to introduce new digital services and
products in 2004 to inspire people to share their photographic memories.*
Marketing Strategy
Our strategy for generating revenues is to leverage the strength of our
services and products for both film-based and digital camera users. In recent
years, we have seen a significant decline in our sales of traditional
photofinishing services and products and we believe that the traditional
photofinishing market will decline further as the digital camera market
continues to expand.*
We offer services and products, primarily in the United States, to digital
camera users and believe we can compete effectively in this market by providing
digital camera owners with professional quality photo output in the form of
prints, reprints and other photo related items.* Net revenues generated by sales
outside the United States accounted for less than 1% of our total net revenues
in fiscal years 2003, 2002 and 2001.
We believe that our future success is dependent on our ability to
transition our services and products to meet the needs of digital camera users
by delivering innovative digital services and products and complete customer
satisfaction. We will continue to introduce or enhance digital related service
and product offerings to support this strategy.*
Commitment to Customer Satisfaction. We seek to develop and provide
high-quality and reliable services and products to enhance brand recognition for
"PhotoWorks" and maintain customer loyalty and we believe that a significant
portion of our business comes from repeat customers.* As part of our dedication
to customer service, PhotoWorks offers a 100% satisfaction guarantee. See
"Business--Customer Service and Support."
New Customers. In recent years, we have seen a decline in the
effectiveness of our customer acquisition programs and we are evaluating and
testing various marketing programs that would generate new customers cost
effectively.* Our primary methods to acquire new customers have been low priced
or free introductory offers. We promote our products and services online and
through our Web site (www.photoworks.com) and we have a customer referral
program for online and mail order customers which encourages existing customers
to suggest family and friends that may be interested in our services and
products. "See "Risk Factors."
3
Services and Products
PhotoWorks offers a variety of value-added, innovative and high-quality
services through which it seeks to differentiate itself from its competitors.*
Although mail-order photofinishing is generally longer than many alternative
sources for photofinishing services, the PhotoWorks(R) online service improves
turnaround time by offering immediate viewing and sharing of images online with
prints to follow in the mail. Turnaround time for traditional mail-in processing
services remains a competitive disadvantage for us. However, we believe that our
turnaround time for online digital printing services is highly competitive
within the marketplace.
PhotoWorks has an established tradition of service and product innovation
for both traditional and digital camera users. The following table illustrates
recent service and product introductions:
Service or Product Year of Introduction
------------------ --------------------
Print Wizard for Microsoft Windows(R)XP users ............ 2003
Pick Your Prints ......................................... 2003
Next Day Prints .......................................... 2003
Mail in service for memory cards and CD's ................ 2002
PhotoVHS ................................................. 2002
Year in Photos(TM)CD ..................................... 2002
PhotoWorks(R)Designer & Custom Greeting Cards Online ..... 2001
PhotoDVD(TM) ............................................. 2001
Browser Uploader ......................................... 2001
Pocket Photo Books ....................................... 2000
Photo Gifts Online ....................................... 2000
In 2003, we added several innovative and convenient services; (i) "Next
Day Prints" provides same day shipping for digital prints ordered online if
customers request overnight shipping; (ii) Print Wizard for Microsoft Windows XP
users allows customers to order professional quality digital prints directly
from their computer through a convenient online order form; and (iii) "Pick Your
Prints" allows film customers that select this option to view high-resolution
photos online and choose only the photos they want printed from their online
account.
In 2002, we introduced the Year in Photos(TM) CD, an affordable and
convenient way for customers to save an entire year of their personal photos on
one CD. We introduced PhotoVHS, a multi-media, movie-like presentation, complete
with a theme, background music, and other professional-quality effects. We also
launched a service to make it even easier for digital camera owners to purchase
professional-quality prints and Pictures On Disk(TM) CDs by allowing them to
mail their memory cards and CDs of their digital images to PhotoWorks for
developing.
In 2001, we introduced several innovative digital and traditional products
and services. PhotoWorks PhotoDVD(TM) allowed customers to view their photos in
a multi-media, movie-like presentation, complete with a theme, background music,
credits and other professional-quality effects. Browser Uploader enabled
customers to easily upload digital images from digital cameras, scanners and
computers to their PhotoWorks online archive and "The Works" provided customers
an easy way to order the most popular PhotoWorks film processing package which
contains two sets of prints, a Pictures On Disk(TM) CD, high resolution
scanning, an index print and negatives in a money-saving bundle. We also
extended our line of digital photo greeting cards by adding Designer Photo Cards
and Custom Photo Cards.
Research and Development
Through internal and external research and development efforts, we have
developed innovative digital media and photofinishing services and products. We
seek to identify customer needs and shifts in consumer preferences in order to
design and refine our services and products. In fiscal years 2003, 2002, and
2001, we incurred research and development expenses of $2,442,000, $1,891,000
and $3,966,000, respectively, primarily in connection with development and
enhancement of our online digital services and products. See Item 7 of Part
II--"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
4
Customer Service and Support
The direct-to-consumer photofinishing business involves contacts with a
large number of customers. For customer convenience, we provide toll-free
telephone access at 1-800-746-8696. We believe that customer satisfaction is
critical to our ongoing success. PhotoWorks has a 100% satisfaction-guarantee
policy under which we will provide a full refund if a customer's complaint
cannot otherwise be resolved. As of November 30, 2003, we had a customer service
staff of 19. These personnel have direct access to our database and are trained
to promote certain of our services and products, as well as to answer questions
regarding order status, basic photography and photofinishing, and use of
PhotoWorks(R) digital and online services.
PhotoWorks maintains a Web site on the Internet (www.photoworks.com).
While online, customers may use the PhotoWorks(R) service to privately view,
upload, store, share, manage, post or email their photos to friends and family
and order prints and photo gifts. Customers may also obtain the status of their
orders, access answers to frequently asked questions, order products and
services, and send email messages to customer service.
Management Information Systems and Technology
We have implemented technology to support customer order processing, image
archiving, and Internet accessibility. These services and systems use a
combination of proprietary technologies and commercially available, licensed
technologies. Internal development is focused on creating and enhancing the
specialized, proprietary software that is unique to the business. We use a set
of applications for:
o Accepting and validating customer orders
o Archiving images
o Internet image viewing, ordering prints and other products
o Managing shipment of products to customers based on various ordering
criteria
Systems have been designed based on industry standard architectures and
have been designed to reduce downtime in the event of outages or catastrophic
occurrences. The systems provide a 24-hour-a-day, seven-day-a-week availability.
We use load balancing systems and redundant servers to provide for fault
tolerance.
The market in which PhotoWorks competes is characterized by rapidly
changing technology, evolving industry standards, frequent new service and
product announcements and enhancements, and changing customer demands.
Accordingly, future success will depend on our ability to:
o Adapt to rapidly changing technologies
o Adapt services to evolving industry standards
o Continually improve the performance, scalability, features, and
reliability of service in response to competitive service and
product offerings and evolving demands of the marketplace
Failure to adapt to such changes would have a material adverse effect on
our business, results of operations, and financial condition. In addition, new
Internet, storage, networking, telecommunications technologies, or other
technological changes could require substantial expenditures by us to modify or
adapt our services or infrastructure.
PhotoWorks has taken a number of precautions against certain events that
could disrupt the operation of our management information systems, including
events associated with continuing software and hardware upgrades. However, we
could still experience systems failures or interruptions, which could have a
material adverse effect on our business, financial condition and operating
results.* See "Risk Factors".
5
Operations
We operate a single laboratory in Seattle, Washington, which is designed
to produce consistent, high-quality photofinishing. Our photo processing system
is designed for 24-hour in-house processing of most digital and photofinishing
orders. Images are printed on photographic paper using state-of-the-art
equipment. Customers are notified via email when their order is shipped and when
the images are available to view online. Although much of the photofinishing and
order handling process has been automated, trained personnel operate machinery
and regularly monitor product quality with the assistance of computerized
control and measurement systems. Other vendors fulfill most photo gift or photo
related merchandise orders.
PhotoWorks can process and print digital images from digital memory cards,
CD's or from digital images uploaded to our website. We have the ability to
process any brand of 35mm color film, 24mm format Advanced Photo System film,
and all 35mm reloadable or single-use cameras.
We believe we have sufficient production capacity with existing facilities
and equipment but could expand our processing facility if necessary to support
increased production levels.
Competition
PhotoWorks faces competition in the consumer digital and photofinishing
market from other online and direct marketers. We also face competition in other
distribution channels from companies that provide digital and photofinishing
services on a wholesale basis to independent retail outlets, and from mass
merchant retail outlets (such as Wal-Mart and Costco), many of which provide
photofinishing services within hours. The largest of the wholesale
photofinishers are Qualex Inc. and Fuji TruColor, Inc. Management believes that
the largest mail order photofinisher is District Photo Inc. (dba York, Clark
Labs, Mystic Color Lab and Snapfish). We also face competition in the online
digital market with competitors such as Ofoto (a Kodak Company) and Shutterfly.
Many of our competitors have substantially greater financial, technical, and
other resources than PhotoWorks.
Management believes its success in the digital and photofinishing industry
will be based on its ability to generate brand awareness through excellent
service, innovative products, excellent quality and excellent value. PhotoWorks
has sought to differentiate its services by offering a number of value-added
services and products and by emphasizing quality and convenience. We also offer
competitive prices for our digital and film based print services. Other
competitors can and do provide similar services and products.* There are no
significant proprietary or other barriers to entry into the digital or consumer
photofinishing industry.
The digital photography industry is characterized by rapidly evolving
technology and consumer demand for services and products. The introduction of
photographic services and products involving new technologies could render
existing services and products obsolete.* Our future success will depend on our
ability to adapt to new technologies and develop new or modify existing services
and products to satisfy evolving consumer needs.* For example, the
commercialization of digital imaging technologies is having an adverse impact on
the photofinishing industry and has among other factors, accounted for our
recent declines in revenues. The continued development of these or other new
technologies or any failure by us to anticipate or successfully respond to such
developments could have a material adverse effect on our business, financial
condition and operating results.* See "Risk Factors."
Suppliers
PhotoWorks obtains its conventional 35mm film from a few large
manufacturers of photographic film, primarily Ferrania USA, and its photographic
paper and chemicals from a single supplier, Eastman Kodak Company. Currently,
substantially all of our purchases from foreign suppliers are paid for in U.S.
dollars. Our mail-order services and products are handled largely through the
U.S. Postal Service and other common carriers. See "Risk Factors."
6
Proprietary Technology
We currently market our services and products under registered and
common-law trademarks and service marks, including PhotoWorks(R), Seattle
FilmWorks(R), PhotoMail(R), Pictures On Disk(TM), and Pictures On Disk(TM) on
CD. See "Risk Factors."
We consider a large portion of our PhotoWorks(R) software, process for
production of Pictures On Disk(TM) and certain other processes to be
proprietary. We make limited patent filings, in part to avoid disclosure of our
competitive strengths. However, we do attempt to protect our proprietary rights
to software through a combination of copyright, trademark and trade secret laws,
employee and third-party nondisclosure agreements, restricting access to certain
portions of our premises, and contractual restrictions on use and disclosure in
our end-user licenses. The legal and practical enforceability and extent of
liability for violations of license agreements are unclear. *
This Report contains trademarks other than those of PhotoWorks.
Governmental Regulation
PhotoWorks' operations, including transmission of digital images over the
Internet, are subject to regulation by the U.S. Postal Service, the Federal
Trade Commission, and various state, local, and private consumer protection and
other regulatory authorities. In general, these regulations govern the manner in
which orders may be solicited, the form and content of advertisements, privacy
issues, information which must be provided to prospective customers, the time
within which orders must be filled, obligations to customers if orders are not
shipped within a specified period of time and the time within which refunds must
be paid if the ordered merchandise is unavailable or returned. The federal
government has not adopted many laws and regulations to specifically regulate
online commerce and communications. However, Congress has enacted legislation
addressing such issues as the transmission of certain materials to children,
intellectual property protection, taxation, and the transmission of sexually
explicit material. In addition, some states have enacted legislation which makes
the transmission of certain kinds of information, such as obscene content and
information which facilitates the commission of criminal acts, a crime.
Legislation enacted by Congress and the state legislatures could result in
additional regulation or prohibition of the transmission of certain types of
content over the Internet or in the imposition of taxes or fees on transactions
conducted over the Internet.* This could result in significant potential
liability to PhotoWorks, as well as additional costs and technological
challenges in complying with mandatory requirements.* See "Risk Factors."
Environmental Compliance
Our photofinishing operations involve the use of several chemicals which
are subject to federal, state and local governmental regulations relating to the
storage, use, handling and disposal of such chemicals. We actively monitor our
compliance with applicable regulations and work with regulatory authorities to
ensure compliance. To the best of our knowledge, we have never received a
significant citation or fine for failure to comply with applicable environmental
requirements. However, changes in environmental regulations or in the kinds of
chemicals used by us could impose the need for additional capital equipment or
other requirements.* See "Risk Factors."
Employees
As of November 30, 2003 PhotoWorks had 208 employees, of whom
approximately 133 were engaged in production operations, 29 in administration,
11 in marketing and business development, 19 in customer service and 16 in
research and development. None of our employees are covered by a collective
bargaining agreement, and we believe relations with our employees are good.
7
Executive Officers of the Registrant
The executive officers of PhotoWorks as of December 9, 2003 were:
Name Age Position
- --------------------------------------------------------------------------------
Philippe Sanchez 39 President/Chief Executive Officer
Michael F. Lass 49 Vice President Operations/Business Development
Loran Cashmore Bond 46 Vice President Administration/Treasurer/Chief
Accounting Officer/Corporate Secretary
Philippe Sanchez has been the President and Chief Operating Officer since
October 2003. From 2001 to 2003, Mr. Sanchez was senior Vice President of
Marketing at Getty Images, a leading imagery company, where he managed worldwide
strategic brand initiatives. From 1995 to 2001, Mr. Sanchez worked for Nike,
Inc. serving in various general management, product marketing and merchandising
roles in Europe, Asia and the Americas. From 1993 to 1995, Mr. Sanchez served as
a licensing manager for Disney's Consumer Products Europe and Middle East out of
the company's European headquarters in Paris.
Michael F. Lass has been a Vice President since September 1988 and is
currently serving as Vice President of Operations and Business Development. Mr.
Lass joined PhotoWorks in 1984 as Manager of Operations. From 1982 to 1984, Mr.
Lass was Vice President and General Manager of Breezin' Sportswear, a
manufacturer and marketer of sportswear, and, from 1980 to 1982, General Manager
and a director of Mountain Safety Research, Inc., a manufacturer of outdoor
recreational products.
Loran Cashmore Bond has been the Vice President of Administration since
October 2001. She has been the company's Chief Accounting Officer and Treasurer
since August 1999. Ms. Cashmore Bond also serves as Corporate Secretary. Ms.
Cashmore Bond joined PhotoWorks in January 1986 as Accounting Manager, and, from
1989 to 1994 was the Controller. In 1994, Ms. Cashmore Bond became an officer of
the Company and Corporate Controller.
RISK FACTORS
In addition to the other information in this report, the following risk
factors should be carefully considered in evaluating us and our business. The
risks and uncertainties described below are not the only ones we face.
Additional risks and uncertainties not presently known to us or that we
currently deem immaterial also may impair our business operations. If any of the
following risks occur, our business, financial condition, operating results and
cash flows could be harmed.
We may require additional funding
At the end of our 2003 fiscal year, we had cash and cash equivalents of
$4,756,000. We believe that, under our current operational plans, cash balances,
and projected future cash flow from operations, we will have sufficient funds
for our operations through at least the next twelve months.* Although we have
reduced our operating expenses, we had significant operating losses in fiscal
years 2002 and 2003. If we are not able to generate sufficient cash from
operations, we may not be able to maintain our business as currently conducted.
In such event, we may need to further reduce our expenditures or seek additional
capital to continue operations.
Declines in photofinishing industry could adversely affect our revenues
We have experienced significant declines in revenues during fiscal years
2003, 2002 and 2001. We believe that this is primarily attributable to declines
in the mail order photofinishing market and the photofinishing industry in
general. This may be in part due to the availability of low priced film
processing options from mass merchants such as Wal-Mart and Costco. In addition,
we believe the market shift away from traditional 35mm film and towards digital
cameras will continue due to the declining prices for and increased availability
and consumer acceptance of digital cameras. We may not be successful in
sustaining profitable film-based photofinishing customers.
8
We may be unsuccessful in increasing revenues from digital services, which would
adversely affect our results of operations.
We are developing additional products and services designed to establish
us as the choice for digital camera users for printing, archiving, sharing,
viewing and managing personal digital images. We believe that this may
contribute to increases in our digital photofinishing revenues and sales of
other image-related services. However, a number of other companies are
attempting to establish this position. Competitors in this area include Ofoto (a
Kodak Company), Snapfish, Shutterfly and other traditional providers of
photofinishing services. We may not be successful against this competition. The
digital print market has not been fully established. Even if we establish a
strong position among consumers for digital services, we may not be able to
generate significant revenues from this market.
We may be adversely affected by actions of competitors
The market for consumer photofinishing and digital imaging services is
highly competitive. Many of our competitors have substantially greater
financial, technical and other resources than we have. We face competition in
consumer photofinishing and digital imaging services from other direct
marketers, online companies, and competitors in other distribution channels,
including much larger companies. Many of these companies provide photofinishing
services on a wholesale basis to independent retail outlets and, in some cases,
through multiple retail outlets owned by the photofinisher or online service
providers. Many of these competitors also provide photofinishing services within
hours. There are no significant proprietary or other barriers to entry into the
traditional photofinishing or digital imaging industry. Many of our competitors
offer similar photofinishing and digital imaging services and products at lower
prices and with a more rapid turnaround time than we offer. Our ability to
compete effectively depends on our ability to differentiate our services by
offering innovative and value-added services and products. Although we believe
we are a leader in developing and marketing innovative photo-related services
and products for traditional and digital camera users, competitors can and do
provide similar services and products. There can be no assurance we will
continue to compete effectively through development of innovative services and
products or that we will respond appropriately to industry trends or to
activities of competitors.
We may be adversely affected by the outcome of litigation
Fuji Photo Film Co., Ltd - We were a defendant in a claim filed by Fuji
Photo Film Co., Ltd., with the International Trade Commission. Fuji alleged that
a number of companies, including the Company's OptiColor subsidiary, violated
patents held by Fuji on single-use cameras by bringing recycled single-use
cameras into the United States for resale. The ITC Commissioners issued a final
order in June 1999 prohibiting PhotoWorks and our subsidiaries from importing
and selling imported recycled single-use cameras. We appealed the ITC
Commissioners' order to the Federal Circuit Court of Appeals and that Court
issued a decision in November 2001, upholding the order against us.
In July 2001, the ITC commenced enforcement and advisory opinion
proceedings against us and several other respondents, based on a complaint filed
by Fuji with the ITC. This complaint alleged that we infringed certain claims of
six of Fuji's patents on single use cameras, through the importation and sale of
certain newly manufactured reloadable cameras. The complaint requested that the
ITC determine that, through these imports and sales, we violated the ITC's
previous order. It also requested that the ITC bring an action in an appropriate
U.S. District Court to seek an injunction and civil penalties for each day in
which an importation or sale violating the order occurred in an amount up to the
maximum provided by the governing statute. In May 2002, an Administrative Law
Judge of the International Trade Commission issued an initial determination that
our reloadable camera infringed three patents owned by Fuji Photo Film Co.,
Ltd., for single-use cameras and recommended that the Commission assess a
penalty of $1,600,000 against us for such infringement.
9
The Commission upheld the infringement determination and, in May 2003,
upheld the $1,600,000 penalty assessment. In September 2003, we negotiated a
settlement agreement with the ITC to reduce the penalty by $600,000 to a total
of $1,000,000. The settlement also included a payment schedule of $250,000 in
each of the next four years beginning in July 2004. We have accrued a penalty
amount of $875,000 ($1,000,000 penalty net of imputed interest of $125,000) in
our fiscal 2003 financial statements for this matter.
There is a risk that Fuji could bring a civil action against us for
damages for patent infringement by reason of sales of cameras that have been
found in the ITC proceedings to infringe Fuji patents. If such a suit was filed
against us, it could have a significantly harmful impact on our financial
condition, results of operations and liquidity. We are unable to determine the
probability or likelihood of such an action.
We may not be able to retain existing customers or acquire new customers at a
reasonable cost
Future revenues and profitability depends in large part on our ability to
retain our current customers and our ability to acquire new digital customers at
a reasonable cost. Historically, we used, and we continue to use,
direct-marketing programs offering low-priced or free introductory offers as our
primary customer acquisition technique. Over the past few years, the cost for
these programs has increased and we have seen a decline in customer response
rates. Our current marketing focuses on customer reactivation and retention and
opportunities to acquire new customers at a reasonable cost. Our customer
acquisition and retention efforts may not be effective. If we do not find a way
to successfully acquire new digital customers, retain our current customers, or
market successfully against competitors, our business, financial condition and
operating results could be harmed.
We may not be able to keep up with rapid technological change in the
photofinishing industry
The photography industry is currently characterized by rapidly evolving
technology and consumer demand for services and products. The introduction of
digital services and products that use new technologies could render existing
services and products obsolete. Our future success will depend on our ability to
adapt to new technologies and develop new or modify existing services, products
and marketing techniques to satisfy changing consumer needs and attract new
customers. The expanded use of digital cameras has had a negative impact on
companies such as PhotoWorks that have primarily processed traditional
film-based images and slides. The development of these or other new
technologies, or failure by us to anticipate or successfully respond to such
developments, could harm our business, financial condition and operating
results.
We may be adversely affected by national events
We rely on the United States Postal Service and other common carriers to
receive and deliver orders. Terrorist attacks and anthrax contamination have
disrupted our deliveries. Additional terrorist attacks or certain alternatives
to safeguard the mail through mail purification devices could cause serious harm
to our business, financial condition and operating results.
A sale or liquidation of the Company may not generate sufficient proceeds for
any distribution to the common shareholders
We have approximately $3,100,000 of long-term liabilities, including
$2,500,000 of subordinated debentures. The debentures are convertible into
Series B Preferred Stock that has a preference on sale or liquidation of the
Company of $5,000,000. In addition, the holders of the Series A Preferred Stock
have a preference on the sale or liquidation of the Company in the amount of
$15,000,000 plus an amount equal to either, (i) the amount, if any, of accrued
and unpaid dividends up to the time of such payment, or (ii) if no dividends
have been declared by the Board of Directors, an amount equal to the amount of
dividends which would have accrued up to the time of such payment at an annual
dividend rate equal to 6% of the Series A issue price. If the Company were to be
sold for an amount less than the aggregate liquidation preferences on the Series
A and Series B Preferred Stock, it is unlikely that any proceeds would be
available for distribution to the common shareholders.
10
Any acquisitions we make could disrupt our business and harm our financial
condition
We may attempt to acquire other businesses that are compatible with our
business, but we have no current understanding, agreement or arrangement to make
any acquisitions. Future acquisitions could result in unforeseen operating
difficulties and expenditures and may absorb significant management attention
that would otherwise be available for ongoing development of our business. Since
we will not be able to accurately predict these difficulties and expenditures,
it is possible that these costs may outweigh the value we realize from a future
acquisition. Future acquisitions could result in issuances of equity securities
that would reduce our shareholders' ownership interest, the incurrence of debt,
contingent liabilities or amortization of expenses related to goodwill or other
intangible assets and the incurrence of large, immediate write-offs.
We experience fluctuations in quarterly results
Our quarterly operating results will fluctuate for many reasons,
including:
- seasonality of consumer photographic activity,
- the mix of products we sell,
- promotional activities we conduct,
- price increases by our suppliers,
- our introduction of new products,
- our research and development activities,
- our competitors' actions,
- fluctuations in the direct-to-consumer market,
- changes in usage of digital services and online commerce,
- changes in the photofinishing industry and,
- general economic influences and conditions.
Demand for our photo-related services and products is seasonal, with the
highest volume of photofinishing activity generally occurring during the summer
months. As a result, our operating results for any period do not necessarily
indicate the results that can be expected for any future period. Our operating
results in a future period may be below the expectations of public market
analysts and investors which may cause the price of our common stock to decline.
We could be required to collect taxes on the products we sell
In accordance with current industry practice, we do not currently collect
sales taxes or other taxes with respect to shipments of goods into states other
than Washington. One or more states may seek to impose sales or tax collection
or other obligations on out-of-jurisdiction companies which engage in electronic
commerce as we do. In addition, states may aggressively attempt to establish
that our Company has presence (nexus) in their state which could subject our
mail order business to sales or other tax collection obligations. A successful
assertion by one or more states that we should collect sales or other taxes on
the sale of merchandise could result in substantial tax liabilities for past
sales, decrease our ability to compete with traditional retailers and otherwise
harm our business.
In November 2001, Congress extended for two years, the Internet Tax
Freedom Act, which placed a moratorium on state and local taxes on Internet
access and on discriminatory taxes on electronic commerce. H.R. Bill 49 seeks to
make the Internet Tax Freedom Act permanent and is currently in the Senate. If
the Senate chooses not to pass this legislation, U.S. state and local
governments would be free to impose new taxes on electronically purchased goods.
The imposition of taxes on goods sold over the Internet by U.S. state and local
governments would create administrative burdens for us and could reduce one
competitive advantage that the purchase of goods over the Internet now
possesses.
11
We rely on key vendors, suppliers and foreign sourcing
We obtain our conventional 35mm film primarily from Ferrania USA, and our
photographic paper and chemicals from a single supplier, Eastman Kodak. In
addition, we acquire photofinishing equipment to maintain and increase
production capacity from various vendors. As there are relatively few suppliers
of film, photographic paper and chemicals, and photofinishing equipment, the
elimination of any one supplier or failure of a supplier to deliver specified
goods could cause a material disruption in our operations and could harm our
business, financial condition and operating results.
We have no significant long-term purchase contracts or agreements to
ensure continued supply, pricing or access to film, paper or chemicals. While we
believe that alternate sources of film, paper, chemicals and equipment are
available, it is possible that we will not be able to continue to meet our
requirements for supplies and equipment, or purchase supplies and equipment in
sufficient quantities or on terms as favorable to us as those currently
available. Also, changing to an alternate supplier may cause delays, reduced
quality or other problems. Our operations may be harmed by political instability
causing disruption of trade with foreign countries in which our contractors and
suppliers may be located. Existing or potential duties, tariffs or quotas may
limit the quantity of certain types of goods that may be imported into the
United States. Sales of our services and products on a direct-to-consumer
mail-order basis largely depend on the U.S. Postal Service and other common
carriers for receipt of orders and delivery of processed film or other products.
Any significant changes in the operations of or prices charged by the U.S.
Postal Service or other common carriers or extended interruptions in postal
deliveries could harm our business, financial condition and operating results.
Our production capabilities, management information systems and technology may
not be viable
We depend on our management information systems and technology systems to
communicate with customers, process orders, provide rapid response to customer
inquiries, manage inventory, and purchase, sell and ship products efficiently.
We periodically replace and upgrade certain portions of our systems software and
hardware. We take a number of precautions against certain events that could
disrupt our management information systems, including events associated with
continuing software and hardware upgrades. Any damages or failures to our
computer equipment, technology systems and the information stored in our data
center could harm our business, financial condition, and operating results.
We continually face risks regarding the availability and cost of labor,
the potential need for additional capital equipment, plant and equipment
obsolescence, quality control, excess or insufficient capacity and disruption in
our operations. Our inability to adapt our systems to new technology or service
our customers with our existing technology could result in a disruption in our
online or photofinishing services and could harm our business, financial
condition and operating results.
Governmental regulation could harm our business
Our operations, including our transmission of digital images over the
Internet, are subject to regulation by the U.S. Postal Service, the Federal
Trade Commission and various state, local, and private consumer protection and
other regulatory authorities. In general, these regulations govern privacy, the
manner in which orders may be solicited, the form and content of advertisements,
information which must be provided to prospective customers, the time within
which orders must be filled, obligations to customers if orders are not shipped
within a specified period of time, and the time within which refunds must be
paid if the ordered merchandise is unavailable or returned. The federal
government has not adopted many laws and regulations to specifically regulate
online commerce and communications. However, Congress has enacted legislation
addressing such issues as the transmission of certain materials to children,
intellectual property protection, taxation, and the transmission of sexually
explicit material. In addition, some states have enacted legislation which made
the transmission of certain kinds of information, such as obscene content and
information which facilitates the commission of criminal acts, a crime.
12
Other legislation currently before Congress and the state legislatures
could result in additional regulation or prohibition of the transmission of
certain types of content over the Internet. This legislation could result in
significant potential liability to us for content transmitted over our Web site,
as well as additional costs and technological challenges in complying with
mandatory requirements. We do not assume responsibility to edit the content of
our customers' photographs, slides, digital images or personal home pages unless
responding to a specific complaint. Legislation which imposes potential
liability for content made available over the Internet through our Web site
could require us to implement additional measures to reduce our exposure to such
liability, which may require us to incur significant costs or discontinue
certain service or product offerings. Although we carry general liability
insurance, such insurance may not cover potential claims of this type or may not
be adequate to compensate us for the amount of these liabilities. Any costs not
covered by insurance incurred as a result of such liability or asserted
liability could harm our business, financial condition and operating results.
Environmental regulations could harm our business
Our photofinishing operations involve the use of several chemicals which
are subject to federal, state and local governmental regulations relating to
their storage, use, handling and disposal. We actively monitor our compliance
with applicable regulations and work with regulatory authorities to ensure
compliance. Changes in environmental regulations or in the kinds of chemicals
used by us may impose the need for additional capital equipment or other
requirements. Any failure by us to control the use or adequately restrict the
discharge of hazardous substances under present or future regulations could
subject us to substantial liability or cause suspension of our operations. Such
liability or suspension of operations could harm our business, financial
condition and operating results.
ITEM 2 - PROPERTIES
The Company's headquarters are located in Seattle, Washington. This 60,000
square foot building which houses our photofinishing and mail order operations,
is occupied under a lease which expires in September 2010.
We also have a lease agreement for 51,000 square feet of office and
production space adjoining our headquarters. This lease expires in September
2005, with an option to extend for an additional five years. In September 2001,
we vacated a portion of the office space and relocated employees to the
headquarters location. We are evaluating any available opportunities regarding
the vacated office space of the building.
We had various leases for our retail store locations. In fiscal 2003, we
negotiated termination agreements for several retail leases. We currently have
three leases for unoccupied space with terms that expire no later than March
2004. All costs related to the retail lease costs were accrued in fiscal year
2003 and were not material to our results of operations.
ITEM 3 - LEGAL PROCEEDINGS
Fuji Photo Film Co., Ltd - We were a defendant in a claim filed by Fuji
Photo Film Co., Ltd., with the International Trade Commission. Fuji alleged that
a number of companies, including the Company's OptiColor subsidiary, violated
patents held by Fuji on single-use cameras by bringing recycled single-use
cameras into the United States for resale. The ITC Commissioners issued a final
order in June 1999 prohibiting PhotoWorks and its subsidiaries from importing
and selling imported recycled single-use cameras. We appealed the ITC
Commissioners' order to the Federal Circuit Court of Appeals and that Court
issued a decision in November 2001, upholding the order against us.
In July 2001, the ITC commenced enforcement and advisory opinion
proceedings against us and several other respondents, based on a complaint filed
by Fuji with the ITC. This complaint alleged that we infringed certain claims of
13
six of Fuji's patents on single use cameras, through the importation and sale of
certain newly manufactured reloadable cameras. The complaint requested that the
ITC determine that, through these imports and sales, we violated the ITC's
previous order. It also requested that the ITC bring an action in an appropriate
U.S. District Court to seek an injunction and civil penalties for each day in
which an importation or sale violating the order occurred in an amount up to the
maximum provided by the governing statute. In May 2002, an Administrative Law
Judge of the International Trade Commission issued an initial determination that
our reloadable camera infringed three patents owned by Fuji Photo Film Co.,
Ltd., for single-use cameras and recommended that the Commission assess a
penalty of $1,600,000 million against us for such infringement.
The Commission upheld the infringement determination and, in May 2003,
upheld the $1,600,000 penalty assessment. In September 2003, we negotiated a
settlement agreement with the ITC to reduce the penalty by $600,000 to a total
of $1,000,000. The settlement also included a payment schedule of $250,000 in
each of the next four years beginning in July 2004. We have accrued a penalty
amount of $875,000 ($1,000,000 penalty net of imputed interest of $125,000) in
our fiscal 2003 financial statements for this matter.
There is a risk that Fuji could bring a civil action against us for
damages for patent infringement by reason of sales of cameras that have been
found in the ITC proceedings to infringe Fuji patents. If such a suit was filed
against us, it could have a significantly harmful impact on our financial
condition, results of operations and liquidity. We are unable to determine the
probability or likelihood of such an action.
We are also involved in various routine legal proceedings in the ordinary
course of our business.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of shareholders during the fourth
quarter of fiscal 2003.
PART II
ITEM 5 - MARKET PRICES AND DIVIDENDS ON COMMON STOCK
Our common stock is traded on the Over the Counter Bulletin Board (OTCBB)
under the symbol "FOTO." The following table sets forth, for the periods
indicated, the high and low sale prices of our Common Stock as reported on the
OTCBB.
High Low
---- ---
Fiscal Year Ended September 27, 2003
First Quarter ........................... $.20 $.07
Second Quarter .......................... .26 .10
Third Quarter ........................... .36 .16
Fourth Quarter .......................... .42 .22
Fiscal Year Ended September 28, 2002
First Quarter ........................... $.20 $.05
Second Quarter .......................... .54 .12
Third Quarter ........................... .34 .18
Fourth Quarter .......................... .21 .15
On December 5, 2003, the last sale price reported for the Company's common
stock was $.59 per share and as of that date, the common stock was held by an
estimated 4,800 shareholders with approximately 467 holders of record.
14
The Company has never declared or paid cash dividends on its common stock
and does not anticipate paying any dividends in the foreseeable future. The
Company is restricted under the covenants of a bank agreement from declaring any
dividends on shares of its capital stock without the bank's prior consent. The
Company currently intends to retain its earnings, if any, for developing its
business.
ITEM 6 - SELECTED FINANCIAL DATA
The selected financial data set forth below with respect to the Company's
consolidated statements of operations for the years ended September 27, 2003,
September 28, 2002 and September 29, 2001 and the Company's consolidated balance
sheets at September 27, 2003 and September 28, 2002 are derived from the audited
consolidated financial statements included elsewhere in this report and should
be read in conjunction with those consolidated financial statements and their
related footnotes. The selected statements of operations data for the years
ended September 30, 2000 and September 25, 1999 and selected balance sheet data
at September 29, 2001, September 30, 2000 and September 25, 1999 are derived
from audited consolidated financial statements, which are not included in this
report.
PHOTOWORKS, INC.
SELECTED FINANCIAL DATA
(in thousands, except per share and share data)
Fiscal Years
-------------------------------------------------------------------------------
2003 2002 2001 2000 1999
==========================================================================================================================
Consolidated Statements of Operations Data:
Net revenues $ 29,416 $ 42,093 $ 56,690 $ 82,061 $ 89,613
Gross profit 7,287 10,474 12,496 21,858 32,645
Operating expenses 11,334 12,351 24,584 57,323 48,940
Net income (loss) (4,075) 3,581(*) (12,122) (34,794) (10,127)
Net income (loss) attributable to
common shareholders $ (4,075) $ 3,581 $ (12,122) $ (37,817) $ (10,127)
============ ============ ============ ============ ============
Diluted earnings (loss) per share $ (.24) $ .21 $ (.73) $ (2.12) $ (.62)
============ ============ ============ ============ ============
Diluted earnings (loss) per share
attributable to common shareholders $ (.24) $ .21 $ (.73) $ (2.31) $ (.62)
============ ============ ============ ============ ============
Weighted average shares and
equivalents outstanding - diluted 16,657,000 17,043,000 16,563,000 16,389,000 16,299,000
============ ============ ============ ============ ============
Consolidated Balance Sheet Data:
Total assets $ 7,662 $ 11,822 $ 12,381 $ 24,662 $ 41,100
Long-term obligations 3,142 2,500 2,594 1,523 521
Shareholders' equity $ 564 $ 4,638 $ 1,045 $ 13,004 $ 32,321
See notes to consolidated financial statements.
(*) During fiscal 2002, the Company realized $5,673,000 of income tax
benefits.
15
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Forward-Looking Information
This report contains forward-looking statements including, without
limitation, statements identified by an asterisk (*). These statements relate to
future events, product or service offerings or the future financial performance
of PhotoWorks. In some cases, you can identify forward-looking statements by
terminology such as "may," "will," "should," "expects," "plans," "anticipates,"
"believes," "estimates," "predicts," "potential," or "continue" or the negative
of such terms and other comparable terminology. These statements only reflect
expectations and estimates of PhotoWorks' management. Actual events or results
may differ materially from those expressed or implied by such forward-looking
statements. Relevant risks and uncertainties include, among others, those
discussed in Item 1 of Part 1 under the heading "Risk Factors" and elsewhere in
this report and those described from time to time in PhotoWorks' other filings
with the Securities and Exchange Commission, press releases and other
communications. All forward-looking statements contained in this report reflect
expectations at the time of this report only, and PhotoWorks disclaims any
responsibility to revise or update any such forward-looking statement except as
may be required by law.
Controls and Procedures
As of September 27, 2003, as part of our annual audit, we carried out an
evaluation, under the supervision and with the participation of the Company's
management, including our Chief Executive Officer and Chief Accounting Officer,
of the effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Exchange Act Rule 13a-14 and 15d-14. Based upon that
evaluation, the Chief Executive Officer and the Chief Accounting Officer
concluded that our disclosure controls and procedures are effective to timely
alert them to any material information relating to the Company (including its
consolidated subsidiaries) that must be included in our periodic SEC filings.
There have been no significant changes in the Company's internal controls or in
other factors that could significantly affect internal controls subsequent to
their evaluation.
We intend to review and evaluate the design and effectiveness of our
disclosure controls and procedures on an ongoing basis and to improve our
controls and procedures over time and to correct any deficiencies that we may
discover in the future. Our goal is to ensure that our senior management has
timely access to all material financial and non-financial information concerning
our business. While we believe the present design of our disclosure controls and
procedures is effective to achieve our goal, future events affecting our
business may cause us to modify our disclosure controls and procedures.
Overview
PhotoWorks, Inc. ("PhotoWorks" or the "Company") is a leading photo
services company dedicated to providing our customers with innovative and
inspiring ways to enjoy and share their photographic memories. PhotoWorks is
committed to helping digital photographers capture, manage, store, and share
their images and enjoy professional-quality prints. We offer an array of
complementary services and products, primarily under the PhotoWorks(R) brand
name.
To promote our services and products, we rely primarily on direct
marketing and online email programs. We believe our complementary value-added
services and products promote customer loyalty and increase customer demand.* We
strive to increase both average order size and order frequency by informing our
existing customer base of our integrated array of services and products. * We
also believe that our online archive of customer images is a viable and economic
opportunity to monetize a customer's "personal equity" by providing image
storage and management services for digital and film based camera users and
through photo output, in the form of digital prints, reprints and gifts.* Our
commitment to expanding our digital service and product offerings, is intended
to support this strategy.* We use email and other direct-marketing media to
communicate with our existing and inactive customers.
16
Our net loss for fiscal 2003 was $4,075,000, compared to net income of
$3,581,000 in fiscal 2002 and a net loss of $12,122,000 for fiscal 2001. Our net
loss for fiscal 2003 was primarily due to a decrease in net revenues, which
reduced our ability to cover our overhead costs, and a penalty amount of
$875,000 (see Item 3 - Legal Proceedings) assessed by the ITC in fiscal 2003.
Net income for fiscal 2002 was primarily due to income tax benefits of
$5,673,000 as a result of the "Job Creation and Worker Assistance Act enacted by
Congress in March 2002 which provided for an economic stimulus package of
temporary business tax incentives. We benefited from a business tax incentive
contained in the bill, which allowed businesses to extend the net operating loss
carry-back period to five years (previously two years) for net operating losses
arising in taxable years ending in 2001 and 2002 (See Note F of Notes to
Consolidated Financial Statements). In fiscal 2002, we also had lower net
revenues as compared to fiscal 2001, which was partially offset by lower
operating expenses. Operating results will fluctuate in the future due to a
number of factors including lower sales, the level and nature of marketing
activities, price increases or decreases by suppliers, introductions of new
products, research and development requirements, legal issues, actions by
competitors, economic conditions, and conditions in the online and
direct-to-consumer market and the digital imaging and photofinishing industry in
general.*
Cost of goods and services consist of labor, postage, supplies, and fixed
costs of production related to our services and products. Marketing expenses
include costs associated with customer acquisition and retention, building brand
awareness, and testing of new marketing programs. Research and development
expenses consist primarily of costs incurred in developing computerized online
image management concepts, developing online photo archiving and photo sharing
services, other digital related services, and creating equipment necessary to
provide customers with new computer-related photographic services and products.
General and administrative expenses consist of costs related to management
information systems, computer operations, human resource functions, finance,
legal, accounting, investor relations, and general corporate activities.
Critical Accounting Policies
Management's Discussion and Analysis of Financial Condition and Results of
Operations discusses our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of the financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
net revenues, and expenses. Our estimates and judgments are based upon our
historical experience, knowledge of economic and market factors, and various
other factors that we believe to be relevant given the circumstances.
Significant policies, methodologies, estimates, and the factors used therein,
are reviewed on at least a quarterly basis with PhotoWorks' Audit Committee.
Actual results may differ from these estimates.
The following is a discussion of the estimates included in our financial
statements that encompass matters of uncertainty, whereby different estimates
could have reasonably been made or changes in such estimates could have a
material impact on the financial statements of PhotoWorks.
Allowance for Doubtful Accounts
The allowance for doubtful accounts is based on our historical percentage
for bad debts as a percentage of sales with consideration given to the aging of
the receivables. Additionally, we review customers with large past due balances
on at least a monthly basis. Based on our assessment of the financial condition
of such customers, past payment history, and other circumstances, we record a
specific allowance for those accounts that we determine may be uncollectible. We
are unable to predict changes in the financial condition of our customers, or
general economic conditions. Accordingly, if circumstances related to either of
these change, our estimate of an appropriate allowance for doubtful accounts
could be materially affected and we may be required to record additional
allowances.
17
Reserve for Obsolete Inventory
We regularly assess the valuation of our inventory and write down those
inventories that are obsolete, or in excess of forecasted usage, to their
estimated realizable value. A reserve for obsolescence is recorded against
inventory for any film or paper inventories that are nearing their expiration
dates. Additional reserves are recorded for slow-moving or discounted stock to
the extent it is estimated the materials may go unused based on historical
inventory turnover, planned changes in marketing promotions or other anticipated
changes in product mix over the next year, seasonality, or other factors.
Estimates of future usage are based on estimates of future sales and product
mix. If actual sales or product mix differs from our estimates, we may need to
record additional reserves for obsolete inventory.
Deferred Revenues
Our deferred revenues relate primarily to a Frequent Customer Program.
Under this program, after processing a certain number of rolls of film within a
stated period of time, a customer receives free processing on their next roll of
film. For each roll of film for which the processing is paid under this program,
we defer a portion of the revenue received and recognize the revenue upon
processing of the free roll, so that revenue from customers in this program is
recognized ratably over all film rolls processed. As of September 27, 2003, we
had $300,000 of deferred revenues remaining under this program. We believe it is
unlikely that all customers in this program will process the requisite number of
rolls that entitle them to the free processing. However, because we had a
limited amount of historical data on which to estimate a percentage of customers
that would not achieve this benefit, we had been deferring the maximum amount of
revenue. During the third quarter of fiscal 2003, we believed we had obtained
adequate information on certain customer segments to begin reducing the
percentage of revenue deferred for these groups. As this program nears its
expiration, we will likely continue to reduce this percentage within a
reasonable range and reduce our deferral of revenues under this program
accordingly. In any event, the net deferred revenues of $300,000 under this
program will be recognized as revenue by January 31, 2004, the expiration date
of the program.
Deferred Tax Assets
We have net deferred tax assets totaling $12,094,000, comprised primarily
of net operating loss carryforwards. Due to our recent history of operating
losses, the uncertainty of future profits, and limitations on the utilization of
net operating loss carryforwards under IRC Section 382, we have recorded a
valuation allowance of $12,094,000 against our net deferred tax assets.
Contingencies
We are subject to various legal proceedings and claims (see Part I, Item 3
- - Legal Proceedings and Note K of Notes to Consolidated Financial Statements),
the outcomes of which are subject to significant uncertainty. SFAS 5, Accounting
for Contingencies, requires that estimated amounts relating to a contingency
should be recorded if it is probable that a liability or gain has been incurred
and the amount can be reasonably estimated. Disclosure of a loss contingency is
required if there is at least a reasonable possibility that a loss may have been
incurred. We evaluate, among other factors, the degree of probability of the
outcome and the ability to make a reasonable estimate of the amounts.
18
Results of Operations
The following table presents information from our consolidated statements
of operations, expressed as a percentage of net revenues for the periods
indicated.
Fiscal Years Ended
-------------------------------------------
September 27, September 28, September 29,
2003 2002 2001
================================================================================
Net revenues 100.0% 100.0% 100.0%
Cost of goods and services 75.2 75.1 77.9
----- ----- -----
GROSS PROFIT 24.8 24.9 22.1
Operating expenses:
Marketing 9.1 10.9 19.5
Research and development 8.3 4.5 7.0
General and administrative 18.2 14.0 13.4
Legal settlements 3.0 -- 1.9
Accrued lease obligations -- -- 1.6
----- ----- -----
Total operating expenses 38.6 29.4 43.4
----- ----- -----
LOSS FROM OPERATIONS (13.8) (4.5) (21.3)
Total other expense (.4) (.5) (.1)
----- ----- -----
LOSS BEFORE INCOME TAXES (14.2) (5.0) (21.4)
Income tax benefits .3 13.5 --
----- ----- -----
NET INCOME (LOSS) (13.9)% 8.5% (21.4)%
===== ===== =====
Net revenues decreased 30.1% to $29,416,000 in fiscal 2003 compared to
$42,093,000 in fiscal 2002. Net revenues decreased 25.7% to $42,093,000 in
fiscal 2002 from $56,690,000 in fiscal 2001. The decreases in net revenues for
fiscal years 2003 and 2002 were primarily due to declines in film-based
processing volumes which we attribute to increased competition, primarily mass
merchants. In addition, we believe that travel and leisure activities were
adversely affected by events surrounding the war in Iraq and the terrorist
attacks in September 2001, thereby contributing to a reduction in overall film
processing volumes. Net revenues from digital-based processing increased in
fiscal 2003 to approximately $2,631,000 compared to approximately $1,267,000 in
fiscal year 2002 and $842,000 in fiscal 2001.
We have experienced declines in the effectiveness of our customer
acquisition programs and have focused our marketing on programs designed to
retain or reactivate customers. Our marketing expenditures in fiscal years 2003
and 2002 have declined significantly as compared to fiscal 2001. Net revenues
from traditional film processing are expected to decline further in fiscal year
2004 as we continue to transition our business to meet the demands of the
digital camera market.*
In fiscal 2002, net revenues included approximately $4,759,000 from
ancillary business, primarily our reloadable camera and retail sales. These
ancillary businesses were phased out during fiscal years 2002 and 2003.
Gross profit as a percentage of net revenues for fiscal 2003 was
relatively unchanged at 24.8%, compared to 24.9% for fiscal 2002. Gross profit
in fiscal 2001 was 22.1%. The increases in gross profit percentage in fiscal
2003 and 2002 was primarily due to an overall increase in net revenue per roll
and increased selling prices for digital services in the second half of fiscal
2003. In addition, we have realized lower labor and materials costs from
efficiencies in digital printing, plus lower customer service and other indirect
overhead costs due to cost savings initiatives. Gross profit fluctuates due to
the seasonal nature of revenues and revenue per order, combined with fixed
operating costs associated with equipment, facilities and fixed overhead costs
related to our products and services. *
19
Total operating expenses for fiscal 2003 were $11,334,000 or 38.6% of net
revenues, compared to $12,351,000 or 29.4% of net revenues for fiscal 2002, and
$24,584,000 or 43.4% of net revenues for fiscal 2001. The increase in operating
costs as a percentage of net revenues for fiscal 2003 was primarily due to
increased costs for research and development, offset by lower marketing and
general and administrative expenses. In addition, fiscal 2003 operating expenses
included $875,000 for costs related to the settlement of a penalty assessment
with the International Trade Commission (see Part I, Item 3 - Legal
Proceedings). The decrease in operating costs in fiscal 2002 compared to fiscal
2001 was primarily due to a significant reduction in marketing expenses and
lower costs for research and development. In addition, fiscal 2001 operating
expenses included $1,094,000 for costs related to the settlement of a class
action lawsuit and $908,000 for estimated costs related to unused facility costs
and store closure reserve. Future periods may reflect increased or decreased
operating expenses due to the timing and magnitude of marketing activities as
well as expenditures related to development of our digital services and
products.*
Marketing expenses in fiscal 2003 decreased to $2,662,000 or 9.1% of net
revenues, compared to $4,567,000 or 10.9% of net revenues in fiscal 2002, and
$11,033,000 or 19.5% of net revenues in fiscal 2001. The decreases in marketing
expenses in fiscal 2003 and fiscal 2002 were primarily due to a shift in our
marketing strategy to target our customer base through retention and
reactivation marketing programs compared to expenditures focused on customer
acquisition. We continue to test and evaluate marketing programs related to
effective customer acquisition. We do not anticipate a significant increase in
the level of marketing expenditures in fiscal 2004. *
Research and development expenses in fiscal 2003 were $2,442,000 compared
to $1,891,000 in fiscal 2002. Research and development expenses in fiscal 2002
were $1,891,000 compared to $3,966,000 for fiscal 2001. The increase in research
and development expenditures in fiscal 2003 was primarily due to increased
investments in new digital related services and products. The decrease in
research and development expenses in fiscal 2002 compared to fiscal 2001 was
primarily due to reductions in staff and related overhead costs. We expect
continued investments in research and development in fiscal 2004. *
General and administrative expenses decreased to $5,355,000 compared to
$5,893,000 in fiscal 2002. General and administrative expenses decreased to
$5,893,000 in fiscal 2002 compared to $7,583,000 in fiscal 2001. General and
administrative costs decreased in fiscal years 2003 and 2002 primarily due to
reductions in staff and related overhead costs, which were partially offset by
increased legal fees.
Other operating expenses for fiscal 2003 included costs related to the
settlement of a penalty assessment with the ITC of $875,000 and fiscal 2001
included costs of $1,094,000 related to the settlement of a class action lawsuit
(see Note K of Notes to Consolidated Financial Statements). In addition, fiscal
2001 operating expenses included $908,000 for estimated costs related to unused
facility costs and a store closure reserve.
Total other expense in fiscal 2003 was $120,000, compared to $215,000 in
fiscal 2002. Other expense in fiscal 2002 was $215,000, compared to $34,000 in
fiscal 2001. Other expense in fiscal 2003 and 2002 consists primarily of
interest expense. Other expense for fiscal 2001 consists primarily of interest
expense and losses on disposals of assets, offset by a negotiated vendor
discount of approximately $675,000 from a fiscal 2000 expenditure.
In fiscal 2003, we recorded net tax benefits of $92,000 related to an AMT
adjustment. Fiscal 2002 included tax benefits of $5,673,000 as a result of a
business tax incentive contained in the "Job Creation and Worker Assistance Act"
a bill, which allowed a business to extend the net operating loss carryback
period to five years (from two years) for net operating losses arising in
taxable years ending in 2001 and 2002. In July 2002, we received a tax refund of
$3,865,000 for our 2001 tax loss and in fiscal year 2003 we received tax
refunds of $1,915,000 related to our 2002 tax loss.
20
Liquidity and Capital Resources
Net cash generated from operating activities in fiscal 2003 was $3,930,000
compared to $1,445,000 in fiscal 2002 and net cash used of $4,596,000 in fiscal
2001. In fiscal 2003, we generated cash from operating activities primarily due
to tax refunds we received of $1,915,000 and the utilization of certain
prepayments for expenditures made in fiscal 2002 of $3,455,000, primarily for
prepayment of postage and other shipping costs and maintenance contracts. In
fiscal 2002, we generated cash from operations due to a decrease in operating
costs as compared to fiscal 2001, combined with the tax benefits discussed
above. In fiscal 2001, we incurred a net loss of $12,122,000 that was partially
offset by non-cash charges related to depreciation and various other operating
expense accruals.
Net cash used in investing activities was $256,000 in fiscal 2003 compared
to $583,000 in fiscal 2002. Net cash used in investing activities was $583,000
in fiscal 2002 compared to net cash generated from investing activities of
$842,000 in fiscal 2001. In fiscal 2003 and 2002, we purchased additional
equipment to support our digital strategy. The increase in net cash generated
from investing activities for fiscal 2001 was primarily due to sales of
securities available-for-sale.
Net cash used in financing activities was $93,000 compared to net cash
used of $2,548,000 in fiscal 2002 and net cash from financing activities of
$4,620,000 in fiscal 2001. Fiscal 2003 included payments for lease obligations
and in fiscal 2002, we paid off our bank loan of $2,350,000. In fiscal 2001, net
cash from financing activities included proceeds from a bank loan and issuance
of Subordinated Convertible Debentures.
The ratio of current assets to current liabilities was 1.46 to 1 at the
end of fiscal 2003 compared to 1.80 to 1 at the end of fiscal 2002 and .67 to 1
at the end of fiscal 2001. The decrease in fiscal 2003 compared to fiscal 2002
is primarily due to a decrease in income tax receivable and prepaid expenses as
discussed above, partially offset by increased cash and cash equivalents and a
decrease in accounts payable. The increase in fiscal 2002 compared to fiscal
2001 is primarily due to an increase in income tax receivable and prepaid
expenses, partially offset by decreases in inventory, accounts payable, and bank
loan payable.
Net capital expenditures during fiscal 2003 totaled $270,000 compared to
$668,000 in fiscal 2002 and $187,000 in fiscal 2001. The expenditures related
primarily to the purchase of additional digital processing equipment. We have
plans for capital expenditures as needed, although at this time we have no
binding commitments.*
As of December 12, 2003, our principal source of liquidity included
approximately $4,094,000 of cash and cash equivalents. We currently anticipate
that existing cash and cash equivalents and projected future cash flows from
operations will be sufficient to fund our operations, including any capital
expenditures, and to service our indebtedness through at least the next twelve
months. * However, if we do not generate sufficient cash from operations to
satisfy our ongoing expenses, we may be required to seek external sources of
financing or refinance our obligations. Possible sources of financing include
the sale of equity securities or bank borrowings. There can be no assurance that
we will be able to obtain adequate financing in the future. See Item 1 of Part
I-"Risk Factors."
As of September 27, 2003, our principal commitments consisted of
obligations outstanding under operating leases, our settlement with the ITC, and
our convertible debentures, detailed as follows (in thousands):
Fiscal Fiscal Fiscal Fiscal Fiscal Future
2004 2005 2006 2007 2008 Years
--------------------------------------------------------
Lease $1,345 $1,070 $ 429 $ 413 $ 410 $ 820
ITC 250 250 250 250 -- --
Convertible debt -- -- 2,500 -- -- --
--------------------------------------------------------
$1,595 $1,320 $3,179 $ 663 $ 410 $ 820
========================================================
21
Inflation
The results of our operations have not been significantly affected by
inflation during any of the last three fiscal years.
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Not material.
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See pages 23 through 39.
22
Report of Ernst & Young LLP, Independent Auditors
Shareholders and Board of Directors
PhotoWorks, Inc.
We have audited the accompanying consolidated balance sheets of
PhotoWorks, Inc. (the Company) as of September 27, 2003, and September 28, 2002,
and the related consolidated statements of operations, shareholders' equity, and
cash flows for each of the three years in the period ended September 27, 2003.
Our audits also included the financial statement schedule listed in the Index at
Item 15(a). These financial statements and schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the consolidated
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
PhotoWorks, Inc. at September 27, 2003 and September 28, 2002, and the results
of its operations and its cash flows for each of the three years in the period
ended September 27, 2003, in conformity with accounting principles generally
accepted in the United States. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.
/s/ ERNST & YOUNG LLP
Seattle, Washington
November 7, 2003
23
PHOTOWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share and share data)
ASSETS
September 27, September 28,
2003 2002
------------- -------------
CURRENT ASSETS
Cash and cash equivalents $ 4,756 $ 1,175
Accounts receivable, net of allowance for doubtful accounts
of $56 and $28 in 2003 and 2002, respectively 28 548
Inventories 652 934
Prepaid expenses 354 3,978
Income taxes receivable -- 1,808
-------- --------
TOTAL CURRENT ASSETS 5,790 8,443
Furniture, fixtures, and equipment,
at cost, less accumulated depreciation (Note D) 1,821 3,346
Lease deposits 51 33
-------- --------
TOTAL ASSETS $ 7,662 $ 11,822
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable $ 1,376 $ 2,024
Accrued compensation 1,260 1,392
ITC penalty, current portion (Note K) 239 --
Accrued taxes 150 150
Income taxes payable 14 --
Current portion of capital lease obligation 2 94
Other accrued expenses 438 495
Deferred revenues 477 529
-------- --------
TOTAL CURRENT LIABILITIES 3,956 4,684
Subordinated convertible debentures (Note E) 2,500 2,500
ITC penalty, non-current portion 636 --
Capital lease obligations, net of current portion (Note C) 6 --
-------- --------
TOTAL LIABILITIES 7,098 7,184
SHAREHOLDERS' EQUITY (Notes G and I)
Preferred Stock, $.01 par value; authorized 2,000,000 shares;
15,000 shares Series A Convertible Preferred Stock authorized,
issued and outstanding in 2003 and 2002, with a liquidation preference
of $15,000,000, plus any unpaid dividends of 6% per year
36,830 shares Series B Convertible Preferred Stock authorized,
none issued or outstanding in 2003 and 2002 -- --
Common Stock, $.01 par value, authorized 101,250,000 shares, issued and
outstanding 16,660,285 and 16,655,285 in 2003 and 2002, respectively 167 167
Additional paid-in capital 15,803 15,802
Retained deficit (15,406) (11,331)
-------- --------
TOTAL SHAREHOLDERS' EQUITY 564 4,638
-------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 7,662 $ 11,822
======== ========
See notes to consolidated financial statements.
24
PHOTOWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share and share data)
Fiscal Years Ended
------------------------------------------------------
September 27, September 28, September 29,
2003 2002 2001
===================================================================================================
Net revenues $ 29,416 $ 42,093 $ 56,690
Cost of goods and services 22,129 31,619 44,194
------------ ------------ ------------
GROSS PROFIT 7,287 10,474 12,496
Operating expenses:
Marketing 2,662 4,567 11,033
Research and development 2,442 1,891 3,966
General and administrative 5,355 5,893 7,583
Legal settlements (Note K) 875 -- 1,094
Accrued lease obligations (Note C) -- -- 908
------------ ------------ ------------
Total operating expenses 11,334 12,351 24,584
------------ ------------ ------------
LOSS FROM OPERATIONS (4,047) (1,877) (12,088)
Other income (expense):
Interest expense (173) (286) (539)
Interest income 42 43 89
Other income (expense), net 11 28 416
------------ ------------ ------------
Total other expense (120) (215) (34)
------------ ------------ ------------
LOSS BEFORE INCOME TAXES (4,167) (2,092) (12,122)
Income tax benefits (Note F) 92 5,673 --
------------ ------------ ------------
NET INCOME (LOSS) $ (4,075) $ 3,581 $ (12,122)
============ ============ ============
Diluted earnings (loss) per share $ (.24) $ .21 $ (.73)
============ ============ ============
Basic earnings (loss) per share $ (.24) $ .22 $ (.73)
============ ============ ============
Weighted average shares diluted 16,657,000 17,043,000 16,563,000
============ ============ ============
Weighted average shares basic 16,657,000 16,655,000 16,563,000
============ ============ ============
See notes to consolidated financial statements.
25
PHOTOWORKS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(in thousands, except share data)
Preferred Stock Common Stock
--------------- ------------
Shares Par Shares Par Paid-In Retained
Outstanding Value Outstanding Value Capital Deficit Total
===================================================================================================================================
BALANCE AS OF SEPTEMBER 30, 2000 15,000 $ -- 16,505,659 $ 165 $ 15,629 $ (2,790) $ 13,004
Warrants issued -- -- -- -- 83 -- 83
Purchase of Storycatcher.com -- -- 86,500 1 59 -- 60
Employee stock purchase plan -- -- 63,812 1 19 -- 20
Net loss -- -- -- -- -- (12,122) (12,122)
----------- ----- ----------- ----------- ----------- ----------- -----------
BALANCE AS OF SEPTEMBER 29, 2001 15,000 -- 16,655,971 167 15,790 (14,912) 1,045
Warrants issued -- -- -- -- 12 -- 12
Employee stock purchase plan -- -- (686) -- -- -- --
Net income -- -- -- -- 3,581 3,581
----------- ----- ----------- ----------- ----------- ----------- -----------
BALANCE AS OF SEPTEMBER 28, 2002 15,000 -- 16,655,285 167 15,802 (11,331) 4,638
Stock options exercised -- -- 5,000 -- 1 -- 1
Net loss -- -- -- -- (4,075) (4,075)
----------- ----- ----------- ----------- ----------- ----------- -----------
BALANCE AS OF SEPTEMBER 27, 2003 15,000 $ -- 16,660,285 $ 167 $ 15,803 $ (15,406) $ 564
=========== ===== =========== =========== =========== =========== ===========
See notes to consolidated financial statements.
26
PHOTOWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Fiscal Years Ended
-------------------------------------------
September 27, September 28, September 29,
2003 2002 2001
================================================================================================================
OPERATING ACTIVITIES:
Net income (loss) $ (4,075) $ 3,581 $(12,122)
Charges to income not affecting cash:
Depreciation 1,802 3,711 5,361
Legal settlements 875 -- 705
Deferred revenues (52) 430 5
(Gain) loss on disposal of furniture, fixtures, and equipment (13) 55 277
Accrued lease obligations -- -- 908
Net change in receivables, inventories, payables and other 3,571 (4,524) (700)
Income taxes receivable/payable 1,822 (1,808) 970
-------- -------- --------
NET CASH PROVIDED BY (USED IN)
OPERATING ACTIVITIES 3,930 1,445 (4,596)
INVESTING ACTIVITIES:
Purchase of furniture, fixtures, and equipment (270) (668) (187)
Proceeds from sales of furniture, fixtures, and equipment 14 85 7
Sales of securities available-for-sale -- -- 1,022
-------- -------- --------
NET CASH PROVIDED BY (USED IN)
INVESTING ACTIVITIES (256) (583) 842
FINANCING ACTIVITIES:
Payment on capital lease obligations (94) (198) (250)
Proceeds from issuance of Common Stock 1 -- 20
Repayment of bank note payable -- (2,350) --
Proceeds from bank note payable -- -- 2,350
Proceeds from Subordinated Convertible Debentures -- -- 2,500
-------- -------- --------
NET CASH PROVIDED BY (USED IN)
FINANCING ACTIVITIES (93) (2,548) 4,620
-------- -------- --------
INCREASE (DECREASE) IN CASH AND
CASH EQUIVALENTS 3,581 (1,686) 866
Cash and cash equivalents at beginning of year 1,175 2,861 1,995
-------- -------- --------
CASH AND CASH EQUIVALENTS
AT END OF YEAR $ 4,756 $ 1,175 $ 2,861
======== ======== ========
Supplemental cash flow information:
Cash paid for interest $ 175 $ 261 $ 356
Cash received from income tax refund $ 1,915 $ 3,865 $ --
Supplemental non-cash financing and investing activity:
Capital lease obligation incurred $ 8 $ -- $ --
Stock warrants issued for bank financing $ -- $ 12 $ 83
Purchase of StoryCatcher.com $ -- $ -- $ 98
See notes to consolidated financial statements
27
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A -- OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PHOTOWORKS, INC: ("PhotoWorks" or the "Company") is a leading photo services
company, dedicated to providing its customers with innovative and inspiring ways
to enjoy and share their photographic memories, primarily through online and
mail-order channels. The PhotoWorks service provides film and image processing
and online image storage and management services to both traditional and digital
camera users, primarily in the United States, which allow customers to store and
organize photos online, share them with friends and family, and order reprints,
photo albums, and photo related products. The Company also offers an array of
complementary products and services, primarily under the brand name
PhotoWorks(R).
PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include
PhotoWorks, Inc. and its subsidiaries, all of which are wholly-owned.
Significant inter-company accounts and transactions have been eliminated in
consolidation.
SEGMENT REPORTING: The Company currently operates in one business segment.
CASH AND CASH EQUIVALENTS: Cash and cash equivalents include cash on hand,
credit card receivables, and highly liquid short-term investments with a
maturity date of three months or less on date of purchase.
OTHER FINANCIAL INSTRUMENTS: The carrying values of financial instruments such
as trade receivables and payables, approximate their fair values, based on the
short-term maturities of these instruments. The ITC penalty settlement and
capital lease obligations were entered into shortly before the end of the fiscal
period and there have been no significant changes in interest rates or credit
risk of the Company since; therefore the carrying values of those financial
instruments also approximate their fair values.
ACCOUNTS RECEIVABLE: Accounts receivable primarily includes amounts due from
wholesale customers from the sale of single-use camera shells. An allowance for
doubtful accounts is established based on the Company's historical loss
percentage for bad debts as a percentage of sales with consideration given the
aging of the receivables.
INVENTORIES: Inventories are stated at the lower of cost (using the first-in,
first-out method) or market. Inventories consist primarily of film, and
photofinishing supplies. An inventory reserve is established based on the
valuation of the Company's inventory, and those inventories which are obsolete
or in excess of forecasted usage or their estimated net realizable value.
DEPRECIATION: Furniture, fixtures, and equipment are depreciated using the
straight-line method based on the estimated useful asset lives, ranging from two
to five years. Expenditures for major remodeling and improvements of leasehold
properties are capitalized as leasehold improvements. Leasehold improvements are
depreciated over the shorter of the life of the lease or the life of the asset.
INCOME TAXES: The benefit or provision for federal income taxes is generally
computed based on pretax income. However, the benefit or provision may differ
from income taxes currently payable or receivable, because certain items of
income and expense are recognized in different periods for financial reporting
purposes than they are for federal income tax purposes. As more fully described
in Note F, the net operating losses for both book and tax purposes exceed
amounts available for operating loss carrybacks. Due to the uncertainty of the
recoverability of these deferred assets, a valuation allowance has been
recorded. Amounts available through operating loss carrybacks are recorded as
income taxes receivable.
28
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE A -- OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
STOCK-BASED COMPENSATION: The Company has adopted the disclosure-only provisions
of Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for
Stock-Based Compensation," and SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition Disclosures," and applies Accounting Principles Board
Opinion No. 25 (APB 25) and related Interpretations in accounting for its stock
option plans. Accordingly, the Company's stock-based compensation expense is
recognized based on the intrinsic value of the option on the date of grant.
Under Statement No. 123, if the Company had elected to recognize the
compensation cost based upon the fair value of the options granted at grant
date, net income (loss) would have been changed as follows:
September 27, September 28, September 29,
2003 2002 2001
-------------------------------------------------
(in thousands, except per share data)
Net income (loss) as reported $ (4,075) $ 3,581 $ (12,122)
Add: Stock-based compensation expense
included in net income, net of related tax benefits -- -- --
Deduct: Stock based compensation as determined
under FAS 123, net of related tax effects (446) (544) (620)
---------- ---------- ----------
Pro forma net income (loss) $ (4,521) $ 3,037 $ (12,742)
========== ========== ==========
Basic earnings (loss) per share as reported $ (.24) $ .22 $ (.73)
Diluted earnings (loss) per share as reported $ (.24) $ .21 $ (.73)
Pro forma basic earnings (loss) per share $ (.27) $ .18 $ (.77)
Pro forma diluted earnings (loss) per share $ (.27) $ .18 $ (.77)
Pro forma information regarding net income (loss) and diluted earnings (loss)
per share has been determined as if the Company had accounted for its employee
stock options under the fair value method of SFAS No. 123. The fair value for
the options was estimated at the date of grant using a Black-Scholes option
pricing model with the following weighted-average assumptions on the option
grant date:
Fiscal 2003 Fiscal 2002 Fiscal 2001
==========================================================================================
Risk free interest rate 2.23% 2.68% 3.81%
Expected volatility 180.85% 134.95% 314.64%
Expected option life 3.33 years 3.00 years 2.70 years
Dividend yield 0.00% 0.00% 0.00%
The pro forma effects on net income (loss) for fiscal years 2003, 2002, and 2001
are not indicative of pro forma effects in future years because additional
grants in future years are anticipated.
REVENUE RECOGNITION: The Company recognizes revenue when products are shipped or
services are delivered. The Company provides its customers with a 100%
satisfaction guarantee. The majority of the Company's products and services will
not be returned but customers can request a refund if not satisfied. During
fiscal year 2003 refunds were less than 1% of net revenues. An allowance is
recorded for expected future returns.
29
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE A -- OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
DEFERRED REVENUES: Deferred revenues relate primarily to a Frequent Customer
Program. Under this program, after processing a certain number of rolls of film
within a stated period of time, a customer receives free processing on their
next roll of film. For each roll of film for which the processing is paid under
this program, the Company defers a portion of the revenue received and
recognizes the revenue upon processing of the free roll, so that revenue from
customers in this program is recognized ratably over all film rolls processed.
EARNINGS (LOSS) PER SHARE: - The Company calculates earnings per share based on
the weighted average number of shares and dilutive Common Stock equivalents
outstanding during the period. Net loss per share is based on the weighted
average number of common shares outstanding during the period. See Note H.
SHIPPING AND HANDLING COSTS: These costs are included in the cost of goods and
services.
ADVERTISING COSTS: Advertising costs are recorded as expenses when incurred.
Direct mail promotional costs of printed promotional materials are recorded as
expenses during the period in which they are mailed or otherwise disseminated to
customers.
USE OF ESTIMATES: The preparation of financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts reported in
the consolidated financial statements and accompanying notes. Actual results
could differ from those estimates.
RECLASSIFICATIONS: Certain prior year amounts have been reclassified to conform
to the current year's presentation.
NOTE B - LIQUIDITY
The Company has experienced significant revenue declines and has incurred
operating losses in recent years. Cash flows from operations were positive in
fiscal 2003 and 2002 primarily due to income tax refunds of $5,780,000 related
to the carryback of taxable losses. Management has taken various actions,
including workforce reductions, store closures, and reduced marketing and
administrative expenditures to more closely align its cost structure with its
reduced revenue levels and to improve its cash flows.
Management believes that under current operational plans, its current cash
balances and projected future cash flows from operations will be sufficient to
fund operations through at least the next twelve months. Further, management has
both the ability and intent to undertake additional actions to reduce expenses
to ensure cash balances are sufficient to meet its obligations as they fall due.
However, the Company's inability to successfully generate sufficient cash flow
from operations would have a material adverse impact on the Company's financial
position and liquidity and may require the Company to seek additional sources of
funding to enable it continue operations for at least the next twelve months.
30
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE C--PROPERTY AND LEASES
The Company has two separate leases related to its main operating facilities,
totaling approximately 110,000 square feet. One of these leases, with lease
costs of approximately $473,000 per year, expires in September 2005, with an
option to extend through September 2010. The other lease, with lease costs of
approximately $410,000 per year, expires in September 2010.
The Company leases the majority of the equipment needed to archive and retrieve
customers' digital images under three-year operating leases. These leases
commenced on the in-service date of the particular equipment and generally
expire during fiscal 2005. Total payments under these equipment leases are
approximately $394,000 annually.
At September 27, 2003, future minimum payments under capital leases and
non-cancelable operating leases are as follows:
Capital Operating
Lease Leases
================================================================================
(in thousands)
Fiscal 2004 $ 3 1,342
Fiscal 2005 3 1,067
Fiscal 2006 3 426
Fiscal 2007 3 410
Fiscal 2008 -- 410
Thereafter -- 820
------- -------
12 $ 4,475
=======
Amounts representing interest (4)