Forward Looking Statements
This Annual Report contains statements that are "forward-looking" and involve a high degree of risk and uncertainty. Words such as "anticipate," "believe," "estimate," "forecast," "intend," "may," "plan," "project," "predict," "should" and "will" and similar expressions as they relate to Advanced Marketing Services, Inc. are intended to identify such forward-looking statements. These include statements related to our plans for future business development activities, and our estimates regarding market sizes and opportunities, as well as our future revenue, profitability, and capital requirements, all of which are prospective. Such statements are only predictions and reflect our expectations and assumptions as of the date of this report based on currently available operating, financial, and competitive information. The actual events or results may differ materially from those projected in such forward-looking statements. Risks and uncertainties and the occurrence of other events could cause actual events or results to differ materially from these predictions. Factors that might cause such a difference include, but are not limited to, those discussed below and in Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations." These risk factors should be considered carefully in evaluating us and our business. These forward-looking statements speak only as of the date of this report. We expressly disclaim any intent or obligation to update these forward-looking statements.
We use market data and industry forecasts throughout this report. We have obtained this information from internal surveys, market research, publicly available information, and industry publications. Industry publications generally state that the information they provide has been obtained from sources believed to be reliable, but that the accuracy and completeness of such information is not guaranteed. Similarly, we believe that the surveys and market research we or others have performed are reliable, but we have not independently verified this information. We do not represent that any such information is accurate.
GENERAL
Advanced Marketing Services, Inc. ("AMS," "we," "our," "us"), provides global customized services to book retailers and publishers. We are a leading wholesaler of general interest books to the membership warehouse clubs and certain specialty retailers, certain e-commerce companies and traditional bookstores. General interest books include bestsellers; basic reference books, including computer and medical books; books regarding business and management; cookbooks; gift books, including art and coffee table books; calendars; travel books; regional books; mass market paperbacks; children's books; and Spanish-language books. In addition, to a lesser extent, we sell pre-recorded audiocassettes (books on tape). In conjunction with our product sales, we provide product selection advice, vendor managed inventory ("VMI") services, specialized merchandising and product development services, promotion and advertising, and logistical and handling services to membership warehouse clubs and other retailers operating in the United States of America ("U.S."), Canada, Mexico, the United Kingdom ("U.K."), Australia, Singapore and certain other Pacific Rim countries. We are also the largest independent contract distributor for small to medium-sized publishers in North America, providing a full range of sales, fulfillment and collection services.
Due to the continuous introduction of new titles by the book publishing industry, we provide weekly recommendations, tailored to each customer's marketing priorities, with respect to the new titles to be sold in our customers' book departments. These recommendations are selected by our buyers from among the over 1,000,000 titles in print and over 150,000 new books published each year. We also create unique products and develop specially packaged book and book-related products for sale to our customers. We support our customers' inventories by maintaining back-up inventory in our distribution centers for prompt delivery as needed to customer locations. We maintain five domestic regional distribution centers to ensure timely delivery to our customers, enhance our customers' inventory turnover rates and reduce our customers' handling and holding costs. See "Properties."
We provide wholesale services to a major warehouse club customer and others in the U.K. and continue to expand our clientele to specialty retailers. Also in the U.K., through our equity interest in The Templar Company, PLC ("Templar"), we design and market children's books that incorporate sophisticated pop-up pictures using high-quality art, including the award-winning Maurice Pledger wildlife series. In Mexico, we wholesale products to a variety of retailers, including warehouse clubs, hypermarkets, discount department stores and other specialty
GENERAL (continued)
retailers. In addition to providing traditional book distribution services to independent bookstores, chain bookstores and department store book departments, our Australian subsidiary provides contract warehousing and direct to consumer capabilities for publishers. We also have a facility in Singapore that replicates our distribution capabilities in Australia to customers in South Asia and independent contract distribution representatives in North Asia. In Canada, through our equity interest in Raincoast Book Distribution, Limited ("Raincoast Books"), we have enhanced our coverage of North America and expanded our distribution network. See "International Business." We published over 400 titles in Fiscal 2003 through our in-house publishing arm, Advantage Publishers Group ("APG"), which manages our Thunder Bay, Laurel Glen, Silver Dolphin and Portable Press imprints.
We were incorporated in 1982 in California and were reincorporated in Delaware in June 1987. Our executive offices are located at 5880 Oberlin Drive, San Diego, California 92121; telephone (858) 457-2500.
RECENT DEVELOPMENTS
On December 6, 2002, our subsidiary, Advanced Marketing (Europe) Limited, acquired all of the outstanding capital stock of two British book distributors, H.I. Marketing Limited ("H.I. Marketing") and Cutsound Limited ("Cutsound"), which does business as Airlift Book Company, for cash consideration of approximately $1.9 million and $1.5 million, respectively. H.I. Marketing sells books in the U.K. on behalf of approximately 20 U.S. and U.K. publishers and is currently the U.K. marketing representative for our subsidiary, Publishers Group West, Inc. ("PGW"). Cutsound sells books in the U.K. to traditional and non-traditional book markets for more than 125 small to medium-sized publishers of primarily alternative books in the health and lifestyle category.
On March 26, 2003, our subsidiary, Advanced Marketing (Europe) Limited, received notice from Safeway Stores Plc. ("Safeway"), the sole customer of our subsidiary, Aspen Marketing Communications Limited ("Aspen"), of its intent to terminate Aspen's contract for the supply of books and maps to Safeway as of June 26, 2003. We have included in our financial statements approximately $0.8 million related to the write-off of impaired goodwill specifically identifiable to Aspen, which we acquired in August 2000.
MEMBERSHIP WAREHOUSE CLUB INDUSTRY
Our customers include for-profit membership warehouse clubs that sell a broad range of primarily brand-name merchandise at or near wholesale prices. Membership warehouse clubs are able to provide their individual and business members, who commonly pay annual membership fees, substantial cost savings on high-quality merchandise through the efficiencies of warehouse-type facilities and a no-frills, self-service operation policy. Membership warehouse club locations typically have more than 130,000 square feet of floor space and offer a limited selection of brand-name products in a wide range of merchandise categories. This merchandising approach was introduced in Southern California in 1976. Since then, the membership warehouse club industry has experienced significant growth, with sales we estimate to be approximately $79.0 billion in 2003.
Only U.S. membership warehouse club locations to which we shipped more than $50,000 per year are included as locations served in the above table.
MEMBERSHIP WAREHOUSE CLUB INDUSTRY (continued)
(2) 63 Canadian locations were serviced by Raincoast Books. See "International Business." (3) 57 Canadian locations were serviced by Raincoast Books. See "International Business." (4) 61 Canadian locations were serviced by Raincoast Books. See "International Business."
We also serve 77 warehouse club locations in Mexico, 15 in the U.K. and ship a limited amount of product to 13 warehouse club locations in various Pacific Rim countries. See "International Business." The number of locations served is not necessarily indicative of our total sales volume to the warehouse club industry as the volume of our shipments to a location may vary from year to year based on competitive and other factors.
Books are well suited to the membership warehouse club merchandising strategy of offering recognizable, quality merchandise at substantial savings. Books appeal to a wide range of consumers and are popular gift items. Additionally, due to their relatively high selling price in relation to their size, books generally provide membership warehouse clubs with above-average sales per square foot of selling space. By offering a continually changing selection of books at a substantial discount from suggested retail prices, membership warehouse clubs encourage retail customers to purchase books for their enjoyment, as gifts and for business needs or interests.
Notwithstanding the appeal of books as a product line, most membership warehouse clubs are not able to apply their standard product purchasing and handling procedures to their book departments. Typically, a membership warehouse club purchases a limited selection of each product category directly from manufacturers who ship to their retail locations. In contrast, in order to be able to offer even a limited selection of books, typically 150 to 350 stock keeping units ("SKUs") at any one time, a membership warehouse club would be required to devote considerable time and resources to selecting from among over 1,000,000 titles in print and over 150,000 new books published each year by thousands of publishing houses. The membership warehouse club also would incur high freight and handling costs to receive deliveries from, and make returns to, the numerous vendors of such books. Thus, the unique nature of books has led many membership warehouse clubs to rely on wholesalers for a major portion of their book purchases. See "Risk Factors."
RETAILERS
Our customers include superstore and retail chain bookstores in the U.S., which offer their customers a vast assortment of books at value pricing. Our customers sell our products at over a thousand retail locations and on the Internet. Retail locations range from 4,000 to 25,000 square feet and carry a range of 18,000 to over 100,000 titles. We now manage the Border's Group, Inc. ("Borders") and Waldenbooks customized mass-market paperback book programs at over 1,200 locations in the U.S.
INDEPENDENT CONTRACT DISTRIBUTION
We provide a full range of global distribution services to publishers under exclusive contractual arrangements. Distribution services include editorial consultation, sales to multiple channels of the book market, marketing and publicity, customer service, warehousing and distribution, billing and collections, and sales and inventory reporting. We represent and sell our publishers' books and related products to a wide variety of retail and wholesale trade accounts, including major national chains, wholesalers, local bookstores and certain gift, gourmet and special sales accounts. With our broad array of books and related products, we are able to place important titles in most genres of the book trade. We compete to sell our products throughout the global book market.
OTHER CUSTOMERS
We supply an assortment of primarily business and computer titles to certain companies in the office product and computer superstore markets. We also serve a variety of other specialty retailers in the children's education discount retail and book businesses. We are continuing to develop relationships with Internet book retailers and provide product on a limited basis to several Internet book retailers.
For many of these customers, we design and recommend media programs to satisfy the unique marketing priorities of each retailer. By constantly updating titles offered, we make it possible for our customers to offer a targeted selection of books and media products without having to develop media merchandising expertise within their own organizations.
PRODUCT SELECTION SERVICES AND PURCHASING PRACTICES
Our warehouse club customers generally compete in the retail trade book market by offering a limited selection of books (typically 150 to 350 SKUs compared to 10,000 to 100,000 titles at national bookstore chains and book superstores) at prices, which are generally 30% to 45% lower than cover price. We provide our specialty retail customers with book programs that range from as few as 50 titles to programs of several thousand titles. Through our contract distribution business, we represent over 15,000 active titles to the book trade and certain non-trade markets. We believe that one of our principal strengths is our ability to select books that will be successful in each customer's selling environment, which is a function of various factors such as customer base, regional characteristics and marketing priorities. This service is important because many of the books we offer have relatively limited sales lives (typically a few weeks to a few months, although the average book life is approximately eight weeks) due to the relatively rapid introduction of new books to replace titles for which demand has decreased. Therefore, customers rely on our expertise and experience to recommend new titles to be added to their book departments.
Our book selection process depends on close working relationships between our general merchandise managers and our major vendors. The process of selecting books generally begins when a publisher's representative submits pre-publication book summaries to our general merchandise managers. A general merchandise manager evaluates each book on the basis of such factors as subject matter and author, suitability for the customers' selling environments, visual appeal, the extent of the publisher's promotion and advertising support, and the estimated number of copies to be printed. We have developed a proprietary software system, called "ED-Eyes," that allows our retail customers and publishers to view, on their desktops, historic statistical information as well as forecasts, to assist in the product selection and product tracking processes. Because we are a major customer of many of our vendors, and, for our independent contract distribution, we have exclusive contracts with our publishers, our vendors often consult with us during pre-publication planning, allowing us to influence the design and packaging of many of the books we purchase. After choosing titles, the general merchandise managers, in conjunction with the general marketing managers, determine which specific titles we will recommend to each customer on the basis of their knowledge of the customer base, regional characteristics and marketing priorities.
Product selection is the responsibility of our Merchandising Department, under the direction of the Executive Vice President -- Merchandising to whom 12 professional managers and a staff of 37 associates report. Each general merchandise manager is responsible for several categories of products which include hardcover bestsellers, mass market paperbacks, cooking, travel, regional, computer, gift books (including art and coffee table books), children's books, calendars, pre-recorded audio and video cassettes, and Spanish-language books.
We usually purchase titles directly from publishing houses at standard book industry wholesaler discounts, which generally exceed retailer discounts. We make use of cooperative advertising allowances that publishers make available to wholesalers and retailers. We do not generally purchase remainder titles, but will occasionally purchase closeout lots of certain titles at higher than normal discounts. Virtually all books sold are returnable to us by our customers for full credit as long as the books are in saleable condition. Consistent with book industry practice, approximately 86% and 87% of the books we purchased in Fiscal 2003 and 2002, respectively, were returnable to the publisher, a practice that substantially reduces our risk of inventory obsolescence. All other books were purchased on a non-returnable or partially returnable basis, often at higher purchase discounts.
We publish a limited number of titles through our in-house publishing arm, APG, which manages our Thunder Bay, Laurel Glen, Silver Dolphin and Portable Press imprints. While our publishing activities remain a limited part of our overall business operations, we have continued to expand these activities through acquisitions as well as the growth of title offerings. Although these activities typically achieve higher product margin, they carry an increased risk of markdown associated with our self-published inventory. The titles are typically sold to both warehouse club customers and independent and chain bookstore customers. The majority of our self-published product is developed in conjunction with major publishers. See "Product Development and Marketing Services."
We make purchases from publishers on varying payment terms. We generally take advantage of discounts for prompt payments, when economically attractive. During the fiscal year ended March 31, 2003, we made purchases from more than 400 publishers. Four publishers individually accounted for 10% or more of our total U.S. purchases in Fiscal 2003. These included Random House Inc., Penguin Putnam, Inc., Time Warner and Simon & Schuster, which accounted for approximately 17%, 14%, 10% and 10%, respectively, of our gross domestic purchases. We continue to open accounts with new publishers and believe that adequate sources of supply exist to meet anticipated
PRODUCT SELECTION SERVICES AND PURCHASING PRACTICES (continued)
growth. As is customary in the industry, we do not maintain long-term or exclusive purchase commitments or arrangements with any publisher as part of our wholesale business. We do have exclusive arrangements, typically lasting three years, with certain small to medium-sized publishers in connection with our contract distribution business. These contracts have no provisions for purchase commitments.
PRODUCT DEVELOPMENT AND MARKETING SERVICES
In addition to selecting from among regularly published books, we provide specially packaged book and book-related products, which are generally not available in retail bookstores. For example, we work with various publishers to create specially packaged items such as a combination of books, shrink-wrapped or slipcased to sell as a single item, or packages that contain a book and a non-book item, such as a stuffed animal with a book. We also work directly with publishers to have books specially reprinted or created for our customers.
We assist in the promotion of the books we sell by creating seasonal merchandising plans and recommending titles based on themes such as Christmas, Back to School, Father's Day and Easter. We also conduct theme-oriented promotions, frequently tied to specially designed products, such as gardening, taxes, health and fitness, and travel. We coordinate special in-store promotions for a select number of our customers. Both our retail customers and we may also take advantage of our cooperative advertising pools of funds whereby we obtain publisher-sponsored advertising for use by our customers and us.
The marketing of our products is under the direction of the Executive Vice President -- Wholesale/Retailer Services to whom 11 professional managers and a staff of 25 sales personnel report. Members of the staff are assigned to specific customers and present new titles, recommend promotions, analyze point-of-sale data and VMI forecasting, coordinate orders and shipments, and handle other customer requests.
PRODUCT DISTRIBUTION AND HANDLING SERVICES
A critical element of our service is the ability to respond quickly to customers' orders because an important financial and operating goal of many of our customers is a high inventory turnover rate. We have established a national network of five regional distribution centers to ensure rapid deliveries to our customers. These distribution centers are located in general-purpose warehouse facilities in the metropolitan areas of Sacramento, California; Indianapolis, Indiana; Baltimore, Maryland; Reno, Nevada; and Dallas, Texas. At our distribution centers, we receive books from multiple vendors and dispatch, using common and contract carriers, consolidated shipments on a weekly basis to customer locations. Weekly deliveries in our wholesale business eliminate the need for customers to stock large inventories on-site and enable our customers to utilize valuable marketing space for other products. Consolidated shipments to our warehouse club customers reduce customer handling and freight costs by eliminating the costs associated with deliveries by multiple vendors. Four of our five distribution centers are linked with our computerized order-processing center at our San Diego, California headquarters, permitting customer orders to be shipped within 24 hours of receipt. Our computer system also enables us to provide information and special reports to assist customers with operations and marketing. For a fee, upon request, we provide additional services, such as stickering books with the customer inventory item numbers and retail sales prices. We believe that all of these services enhance our customers' inventory turnover rate and reduce their handling and holding costs.
Our VMI proprietary software system is designed to reduce our customers' need to write individual location orders and further improve their inventory turnover. The VMI software we developed forecasts future book sales based on the expected life cycle of a particular title. These forecasts, coupled with customer point of sale information, enable us to effectively offer advice to manage customer laydown and replenishment orders for each customer location.
To further enhance our service capabilities, we continue to utilize software and material handling equipment ("Acupak") in our distribution facilities in Sacramento, Indianapolis, Baltimore and Dallas. The Acupak system increases our efficiency in handling customer orders, and permits us to service additional customers requiring less than a full carton of a particular title.
INTERNATIONAL BUSINESS
We operate wholly owned foreign subsidiaries in the U.K., Mexico, Australia and Singapore. International operations represented 9.3%, 8.4% and 7.2% of world-wide net sales in Fiscal 2003, 2002 and 2001, respectively. We expect international sales to grow in absolute dollar terms consistent with the trend for the past three years.
In December 2002, Advanced Marketing (Europe) Limited acquired two British book distributors, H.I. Marketing and Cutsound, for cash consideration of approximately $1.9 million and $1.5 million, respectively. H.I. Marketing sells books in the U.K. on behalf of approximately 20 U.S. and U.K. publishers and is currently the U.K. marketing representative for PGW. Cutsound sells books in the U.K. to traditional and non-traditional book markets for more than 100 small to medium-sized publishers of primarily alternative books in the health and lifestyle category.
Advanced Marketing (U.K.) Limited was incorporated in September 1993 in the U.K. In 1997 we formed Advanced Marketing (Europe) Limited to serve as a holding company under which all of our U.K. entities are consolidated before consolidating into AMS world-wide. In 1998 and 1999 we acquired two other book distributors in the U.K., Aura Books, Plc and Metrastock Limited, through our holding company. In Fiscal 2001, we similarly acquired Aspen, a wholesale distributor of specialty books to the Safeway store chain in the U.K. On March 26, 2003, Advanced Marketing (Europe) Limited received notice from Safeway, the sole customer of Aspen, of its intent to terminate Aspen's contract for the exclusive supply of books and maps to Safeway as of June 26, 2003. We have included in our financial statements approximately $0.8 million related to the write-off of impaired goodwill specifically identifiable to Aspen.
Located in Bicester, Oxfordshire, our 74,000 square-foot mezzanined distribution center services the 15 locations of a major warehouse club, a major national retail chain store, national department stores, and over 2,000 garden centers and specialty retail outlets in the U.K., and provides potential capacity for further growth through strategic acquisitions and expansion of our customer base.
In June 2001, we acquired a 25% equity interest in Templar. Located in the U.K., Templar is a designer of children's books that incorporate sophisticated pop-up pictures using high quality art, including the award-winning Maurice Pledger wildlife series. Templar markets its products world-wide.
Advanced Marketing S. de R.L. de C.V. was incorporated in January 1994 in Mexico. From our headquarters in Mexico City we distribute books to 77 membership warehouse club locations, as well as to a variety of general and mass merchandisers, office supply superstores and other specialty retailers. We have expended significant effort in developing relationships with Mexican publishers. This strategy continues to assist our expansion efforts in Mexico and Central and South America and product-sourcing opportunities for the Spanish language market in the U.S.
In an effort to increase our presence in North America, in September 1999 we acquired a 25% equity interest in Raincoast Books. Headquartered in Vancouver, British Columbia, Raincoast Books has served the Canadian bookselling community since 1979 and has the exclusive Canadian distribution rights for approximately 40 publishers, in addition to serving as the Canadian publisher for the Harry Potter series. Raincoast Books also performs wholesaling services for certain customers and has extensive publishing operations. On January 31, 2002, our affiliate, Raincoast Books, purchased the Canadian distribution business of our subsidiary, PGW.
In March 2000, we acquired Bookwise International ("Bookwise") with operations based in Adelaide, Australia and sales offices in Sydney and Auckland, New Zealand. Bookwise is a distributor of specialty books in a wide variety of subject areas including art, design, architecture, crafts, photography, cooking, gardening, wine, travel, health, music and children's non-fiction. Bookwise exclusively represented 45 publishers at the time of acquisition, which has grown to over 100 as of March 31, 2003. Plans to double the number of publishers represented in the region is assisted by the close connection with PGW publishers world-wide. Bookwise has a trade account base of over 1,500 customers, serving traditional bookstores, chain bookstores and department and specialty stores in Australia and New Zealand. Bookwise publishes its own list under the "Cameron House" imprint.
Using Bookwise as our expansion platform, in September 2001 we began operations in Southeast Asia establishing a Bookwise Asia office and warehouse in Singapore. Bookwise Asia allows AMS to diversify its core distribution role in the Pacific Rim by leveraging existing publisher, supplier and customer relationships from Australia and New Zealand in a new geographic region. As of March 31, 2003, Bookwise Asia represents 25 publishers. We plan to continue to use Bookwise as our platform for expansion into Asia and the Pacific Rim markets. The unique nature of customers and buying patterns in these markets requires strong local presence to capitalize on expected growth in specialty and warehouse type stores.
BUSINESS STRATEGY
Our business strategy is to provide global customized services to book retailers and publishers. These services include effective book purchasing advice, sales and marketing, promotion and advertising, credit and collection, along with handling and logistical services for our customers. We believe that we are a leading book supplier to membership warehouse clubs, specialty retailers, e-commerce retailers, and even to large traditional chain bookstores because of our ability to offer sound product selection advice, specialized product development and marketing services, along with accurate and rapid product delivery at competitive prices. Additionally, we seek to diversify our business by adding new accounts both domestically and internationally, making strategic global acquisitions, enhancing our value-added capabilities to our customers by shipping direct to consumers, expanding our higher margin and low risk contract distribution competency and developing unique products for our customers through our proprietary publishing activities. In December 2002, our U.K. subsidiary, Advanced Marketing (Europe) Limited, acquired two British contract book distributors, H.I. Marketing and Cutsound, in each case further expanding and diversifying our global distribution business. See "Recent Developments."
In order to fulfill our business strategy, we began five years ago to significantly invest in staff, space and systems. We first deliberately filled important upper management positions with individuals who had relevant experience. Second, as the leases for existing distribution centers in the U.S. expired, or as we outgrew them, we moved to new distribution centers that were much larger than what was required for our existing wholesale needs to allow for future growth. This was the result of our strategic decision to enter the contract distribution business in the U.S. We knew from our planning process, and from our investment in Raincoast Books and our acquisition of Bookwise, that contract distribution was an extremely space-intensive business. Our acquisition of PGW was intended to and has made us the largest contract distributor of independent publishers in North America. Together with our international infrastructure these acquisitions have created what we believe is the only contract distribution company for independent publishers to have a global presence. Finally, we completed a significant portion of the upgrade and conversion of our core operating software to a new Oracle Enterprise Resource Planning ("ERP") system as well as a Warehouse Management system in the second quarter of Fiscal 2003, with the final and most significant component of that process to take place early in the second quarter of Fiscal 2004.
These investments in the areas of staff, space and systems will position AMS for substantial future growth while reducing distribution and administrative expenses as a percentage of net sales over the next few years. We are only beginning to experience the efficiencies that will be generated by our new systems. Our staff continues to strategically plan for consistent growth and performance. Our current distribution center capacity has allowed us to better service existing clients and to engage in discussions with substantial new ones. We expect that our new information systems will allow us to create the common "backbone" for our diverse domestic and international operations, as well as to continue to create state-of-the-art software support for both our existing and new customers. We believe that these substantial infrastructure investments are required to continue to maintain our competitive advantage and create a platform for future sales, margin and profit growth.
SEASONALITY
Our business is seasonal, with the highest net sales and earnings occurring in our third fiscal quarter. Income from operations during the third fiscal quarter, as a percentage of net sales, is typically higher than in any other quarter because of product sales mix and other economies of scale caused by the higher sales volume. During Fiscal 2003, we had net sales of $294.8 million and operating income of $14.2 million in the third quarter. This seasonal pattern reflects the increased demand for books and related media experienced during the holiday selling season. Working capital requirements are generally highest during the second and early part of the third fiscal quarters due to the seasonality of our business. We experience significant seasonal short-term swings in our cash position due to sales seasonality and to differences in timing of payments to our vendors and the receipt of payments from our customers. Cash flow has been historically greatest during the third fiscal quarter due to higher seasonal sales. Our results of operations depend significantly upon net sales generated during the third fiscal quarter.
COMPETITION
We are a leading supplier of books to the membership warehouse club market, which is highly competitive. We compete in such markets with national book wholesalers, some of which are larger than we are, and with regional book wholesalers and local book jobbers with whom we compete on the basis of price and service. Certain publishers
COMPETITION (continued)
sell directly to membership warehouse clubs, and one or more of our customers could choose in the future to purchase more of its books directly from publishers. As a result, we could face additional competition from publishers in the future. Membership warehouse clubs face competition from discount and retail bookstore chains that may indirectly affect us. Due to their high sales volume, membership warehouse clubs may represent an attractive market that other book wholesalers may seek to enter and compete directly with us. We believe that our principal competitive advantages are the ability to select, package, and assort products so that they sell in high volumes; to distribute such products rapidly; to electronically interface with customers; to assist in the efficient management of purchasing through our proprietary VMI software; to efficiently manage inventory; to maintain sufficient back-up inventories; and to price products competitively.
We are the leading independent distributor for small to medium-sized publishers in the North American market, which is highly competitive. Our competition in distribution services comes from a number of smaller, privately held, contract distributors and, to a lesser degree, from some of the larger publishers who provide distribution services to other publishers. Competition is based upon a number of factors, including sales penetration abilities, marketing support, technical delivery expertise, distribution and fulfillment capabilities, and financial, sales and inventory reporting. We believe our competitive advantages include our broad editorial mix, our strong national and field sales forces, our ability to consolidate orders, shipping and collections, and our ability to ship from multiple warehouses, thereby decreasing freight expense and decreasing product time-to-market. Most inventory is held on a consignment basis for distribution client publishers, which reduces our risk for obsolescence.
RISK FACTORS
The following section describes some, but not all, of the risks and uncertainties that we believe may adversely affect our business, financial condition or results of operations.
Our Sales are Highly Concentrated in the Membership Warehouse Club Industry
In Fiscal 2003, approximately 65% of our world-wide net sales were to membership warehouse clubs with the remainder to retail chain bookstores, office product superstores, computer superstores, Internet retailers, and other specialty retailers. SAM's Club (a unit of Wal-Mart Stores, Inc.) and Costco Wholesale Corporation accounted for approximately 59% of that figure. Although we believe we provide services and efficiencies that membership warehouse clubs and other retailers would have difficulty duplicating, there is a risk that our customers may, from time to time, increase the percentage of books they purchase directly from publishers or from other wholesale distributors. Furthermore, we could lose customers if they discontinue books as a product line, suffer a business failure or merge or consolidate with another entity that we do not currently service. We have no long-term or exclusive purchase commitments with any of these membership warehouse club customers. Any loss of a major customer would have a materially adverse effect on our business. Given the relatively small number of membership warehouse club chains, our reliance on a few customers is likely to continue. See "Customers."
We Purchase Books from a Highly Concentrated Group of Publishers
In Fiscal 2003, we purchased books from four publishers who individually accounted for more than 10% of our total purchases. These included Random House Inc., Penguin Putnam, Inc., Time Warner and Simon & Schuster, which accounted for approximately 17%, 14%, 10% and 10%, respectively, of our gross domestic purchases. We continue to open accounts with new publishers and believe that adequate sources of supply exist to meet anticipated growth. However, given that certain titles or authors may be exclusive to a particular publisher, we may be reliant upon a given publisher in certain situations. As is customary in the industry, we do not maintain long-term or exclusive purchase commitments or arrangements with any publisher as part of our wholesale business. We do have exclusive arrangements, typically lasting three years, with certain small to medium-sized publishers in connection with our contract distribution business. These contracts have no provisions for purchase commitments.
The Membership Warehouse Club Market is Highly Competitive
We are a leading supplier of books to the membership warehouse club market, which is highly competitive. We compete in such markets with national book wholesalers, some of which are larger than we are, and with regional book wholesalers and local book jobbers with whom we compete on the basis of price and service. Certain
RISK FACTORS (continued)
publishers sell directly to membership warehouse clubs, and one or more of our customers could choose in the future to purchase more of its books directly from publishers. As a result, we could face additional competition from publishers in the future. Membership warehouse clubs face competition from discount and retail bookstore chains that may indirectly affect us. Due to their high sales volume, membership warehouse clubs may represent an attractive market that other book wholesalers may seek to enter and compete directly with us.
The Distribution Services Market is Highly Competitive
We are the leading independent distributor for small to medium-sized publishers in the North American market, which is highly competitive. Our competition in distribution services comes from a number of smaller, privately held, contract distributors and, to a lesser degree, from some of the larger publishers who provide distribution services to other publishers. Competition is based upon a number of factors, including sales penetration abilities, marketing support, technical delivery expertise, distribution and fulfillment capabilities, and financial, sales and inventory reporting.
Book Sales are Closely Tied to General Consumer Spending Trends and Reliance on Best-Sellers
A decline in consumer spending on books or other media could have a material adverse effect on our financial condition, results of operations and our ability to fulfill and fund our growth strategy.
We May Purchase Books That We Cannot Sell or Return
We purchase certain titles on a non-returnable basis, which we in turn may sell on a returnable basis. To the extent that actual sales of such titles do not equal purchased quantities, we risk having inventory that we may be unable to sell at or above our cost. We attempt, wherever possible, to sell-through such remainder product. In addition, we have implemented policies to evaluate more completely and accurately the non-returnable inventory risk we assume. We have incurred substantial expense in the past to sell such excess inventory and may incur such expense in the future. Although we believe our recorded reserves are adequate to cover our exposures, in the event that we are unable to sell remainder product, and depending on the volume of non-returnable inventory purchased that is returned to us from our customers, we increase our risk for markdown expense. Also, both domestic and international self-published and developed titles, while often providing higher profit margins than our regular distribution activities, increase our risk for markdown expense in the event that we are unable to sell-through these titles to our customers.
We are Exposed to Certain Product Liability Risk on Our Self-Published Titles
For our self-published and developed titles, we often work with various manufacturers for book kits and other packaged toy product, and we also work with individual authors and publishing houses to develop and publish titles under our own imprints. Additionally, many of the children's book and toy products we publish may have parts included in the packaging. We attempt to contract with each vendor that manufactures these products to indemnify us against any defective merchandise that they manufacture. Additionally, we also subject parts within the book kits to required testing. In the event that any of the parts are defective, we may be required to recall all or part of that product. Such a recall could result in a loss of sales or additional expenses to transport defective product and legal expenses, among others. To the extent that we are unable to recoup from vendors our losses for the recall, it may result in a decrease to our earnings.
We Must Effectively Manage Changes in Our Business
In order to respond to the business cycles of the book distribution industry, in the past few years we have changed the scope of our operations, our information systems infrastructure and the number of employees in many of our departments. As the book distribution industry changes we will need to continue to:
o closely manage our domestic and international operations;
o improve our accounting and other internal management systems;
RISK FACTORS (continued)
o improve our quality control, order fulfillment, field service and customer support capabilities;
o quickly adapt to changing sales and marketing channels;
o effectively manage our inventory levels; and
o attract, train, retain and manage key technical and operational personnel.
If we fail to effectively manage changes in our business, our operating results, financial condition and cash flows, would be adversely affected.
Our International Expansion and Acquisitions Create Additional Risks Specific to Foreign Countries
An important component of our strategy is our continued expansion and growth as a global operation. However, our expansion into international markets has additional risks. It is costly to acquire and establish international facilities and operations, and integrate those facilities into our existing international operations. Sales from our international subsidiaries may not offset the expense of establishing and maintaining the related operations and, therefore, these operations may not be profitable on a sustained basis. We are also subject to a number of risks inherent in selling abroad, including, but not limited to, risks with respect to foreign exchange rate fluctuations, local economic and political conditions, restrictive governmental policies and laws (such as trade protection measures, limitations on the repatriation of funds, nationalization and consumer protection laws and restrictions on pricing or discounts), difficulty in developing and simultaneously managing a larger number of unique foreign operations as a result of distance, language and cultural differences, tax and other laws and policies of the U.S. and other jurisdictions and geopolitical events, including war and terrorism. In addition, local companies may have a substantial competitive advantage because of their greater understanding of, and focus on, the local customer, as well as their more established local name recognition. Also, we may not be able to hire, train, retain, motivate and manage required personnel, which may limit our growth internationally. Accordingly, our future results could be materially adversely impacted by changes in these or other factors.
We Are Exposed to Foreign Exchange Risk
Our exposure to foreign exchange rate fluctuations arises in part from intercompany transactions that are typically denominated in the functional currency of the foreign subsidiaries. We are also exposed to foreign exchange rate fluctuations as the financial results of our foreign subsidiaries are translated into U.S. dollars during consolidation. As exchange rates vary, these results, when translated, may vary from expectations and may adversely impact overall expected profitability.
We Experience Significant Short-term Swings in Our Cash Position Due to the Seasonality of Our Business
Our business is seasonal, with the highest net sales and earnings occurring in our third fiscal quarter. Income from operations during the third fiscal quarter, as a percentage of net sales, is typically higher than in any other quarter because of product sales mix and other economies of scale caused by the higher sales volume. During Fiscal 2003, we had net sales of $294.8 million and operating income of $14.2 million in the third quarter. This seasonal pattern reflects the increased demand for books and related media experienced during the holiday selling season. Working capital requirements are generally highest during the second and early part of the third fiscal quarters due to the seasonality of our business. We experience significant seasonal short-term swings in our cash position due to sales seasonality and to differences in timing of payments to our vendors and the receipt of payments from our customers. Cash flow has been historically greatest during the third fiscal quarter due to higher seasonal sales. Our results of operations depend significantly upon net sales generated during the third fiscal quarter, and any significant adverse trend in the net sales of such period would result in lower net sales for the full fiscal year. We expect seasonality in operations to continue.
We Are Reliant on a Few Key Personnel
We believe that there are certain key employees within the organization, primarily in the senior management team, who are necessary for us to meet our objectives. In addition, uncertainty created by turnover of key employees could result in reduced confidence in our financial performance, which could cause fluctuations in our stock price
RISK FACTORS (continued)
and result in further turnover of our employees. The loss of one or more key employees could interrupt our continued operations and make it more difficult to implement our business strategies. We do not maintain "key man" life insurance on any of our key officers.
The Cost of Insurance May Increase and We May Bear Additional Risk
We contract for insurance to cover a variety of potential risks and liabilities in the global insurance market. In the current market, insurance coverage is becoming more restrictive, and when insurance coverage is offered, the deductible for which we are responsible is larger. In light of these circumstances, it may become more difficult to maintain insurance coverage at historical levels, or if such coverage is available, the cost to obtain or maintain it may increase substantially. This may result in our being forced to bear the burden of an increased portion of risks for which we have traditionally been covered by insurance.
We are also subject to the possibility of uninsured losses from risks such as terrorism, earthquakes, or floods, for which no, or limited, insurance coverage is maintained. We have elected not to maintain insurance coverage for losses resulting from terrorism, based upon our assessment of the insurance cost and the likelihood of loss. Our earnings would be reduced by the amount of any uninsured losses.
A Change in Accounting Treatment for Employee Stock Options Could Reduce Our Earnings and Reduce Our Ability to Attract and Retain Qualified Employees
We currently account for the issuance of stock options under Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." If proposals currently under consideration by accounting standards organizations and governmental authorities are adopted, we may be required to change our practice. As a result, we could decide to reduce the number of stock options granted to employees or to grant options to fewer employees. This could reduce our ability to retain existing employees and attract qualified candidates, and increase the cash compensation we would have to pay to them. In addition, such a change could reduce our earnings by increasing our expenses.
We Are Reliant on Our Ability to Retain and Attract Qualified Employees
We believe that our future success depends upon our ability to continue to train, retain, effectively manage and attract highly skilled managerial, sales and marketing and technical personnel. We invest significant resources in recruiting and retaining employees. If our efforts in these areas are not successful, our costs may increase, development and sales efforts may be hindered and our customer service may be degraded.
Our Stock Price is Subject to Fluctuations That Could Expose Us to Lawsuits
The trading price of our common stock has in the past and may in the future be subject to fluctuations in response to factors such as the following:
o revenue or results of operations in any quarter failing to meet the expectations, published or otherwise, of the investment community;
o changes in recommendations or financial estimates by securities analysts;
o rumors or dissemination of false and/or misleading information, particularly through Internet chat rooms, instant messaging and other means of rapid dissemination;
o changes in management;
o conditions and trends in the wholesale or retail distribution industry;
o announcement of acquisitions or other significant transactions by us or our competitors; and
o adoption of new accounting standards affecting the wholesale/retail distribution industry.
In addition, fluctuations in the price of our common stock may expose us to the risk of securities class action lawsuits. Defending against such lawsuits could result in substantial costs and divert our attention and resources. Furthermore, any settlement or adverse determination in such a lawsuit could subject us to significant liabilities.
CUSTOMERS
Our major customers include three membership warehouse clubs and one retail chain bookstore. Three of our customers account for over 95% of the sales in the warehouse club industry and operate over 1,000 locations throughout the U.S., Canada, Mexico, the U.K. and certain Pacific Rim countries. Taking into account domestic and international activities, the following table sets forth those customers who accounted for 10% or more of our total net sales in Fiscal 2003, 2002 and 2001. EMPLOYEES
As of March 31, 2003, we had approximately 1,500 full-time employees world-wide who were engaged in administrative, merchandising, marketing and warehousing operations. When hiring new employees, we consider a number of factors, including education and experience, personality and orientation towards customer service. We also hire temporary workers, primarily during the peak holiday season. None of our employees are represented by a labor union. We believe our relations with employees are generally excellent.
AVAILABLE INFORMATION
We are subject to the information requirements of the Securities Exchange Act of 1934 (the "Exchange Act"). Therefore, we file periodic reports, proxy statements, and other information with the Securities and Exchange Commission (the "SEC"). Such reports, proxy statements, and other information may be obtained by visiting the Public Reference Room of the SEC at 450 Fifth Street, NW, Washington, DC 20549 or by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site at http://www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically.
Our Internet address is http://www.advmkt.com. We make available through our Internet website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such reports and amendments are electronically filed with or furnished to the Securities and Exchange Commission.
