CD Warehouse, Inc. (together with its wholly owned subsidiaries, the "Company") is engaged in the franchising and ownership of music stores offering new and pre-owned compact discs ("CDs") and related products under two similar but distinct franchise systems, "CD Warehouse" and "Disc Go Round." The term "CD Warehouse System" encompasses the two franchise systems and their respective stores, which variously operate under the trade names "CD Warehouse," "Disc Go Round", "CD Exchange" and "Music Trader." Since its initial public offering in January 1997 (the "IPO"), the Company has engaged in a program of expansion to achieve strong market recognition in the retail music industry. This expansion has been accomplished primarily through the sale of new franchises and the acquisition and conversion of independently owned retail music stores to company-owned stores, as well as the acquisition by the Company of existing franchised stores. During 1999, the most significant factor contributing to the Company's store and revenue growth was the acquisition of Music Trader, Inc., a 16-store retail music chain based in Southern California. At December 31, 1999, the CD Warehouse System had an aggregate 339 stores in 39 states and the District of Columbia, Canada, England, France, Guatemala and Venezuela, with 185 franchised stores and 75 company-owned stores operating under the CD Warehouse concept (utilizing either the CD Warehouse, CD Exchange or Music Trader trade name) and 79 franchised stores operating under the Disc Go Round concept (utilizing either the Disc Go Round or CD Exchange trade name). The term "CD Warehouse" encompasses the CD Warehouse, CD Exchange and Music Trader stores operating within the CD Warehouse franchise system, and the term "Disc Go Round" encompasses the Disc Go Round and CD Exchange stores operating within the Disc Go Round franchise system.
CD Warehouse and Disc Go Round stores sell their products to the general public in the market area where the respective store is located. A typical store, located in a high traffic strip shopping center, will occupy between 1,200 and 2,500 square feet and offer between 10,000 and 16,000 selections, with approximately 52% of the dollar sales volume being pre-owned selections and the balance being new releases from the major music categories. At each CD Warehouse and Disc Go Round store, a customer selects from a number of new and pre-owned CDs and may listen to pre-owned CDs before purchase. CD Warehouse and Disc Go Round stores sell CDs, take customers' CDs in trade or buy customers' CDs for cash. Typically, each store carries the majority of the Billboard Top 100 selections as "new" inventory, filling out its inventory selection with pre-owned CDs which are purchased for $1 to $4 and remarketed for $6 to $9.
During the year ended December 31, 1999, the Company had total revenues of approximately $31,912,000, and net loss of approximately $1,141,000. The Company's expansion strategy for 2000 is to open 25 to 30 franchised stores. The Company also plans to further develop and market its internet site, HTTP://WWW.CDWAREHOUSE.COM, which offers both new and used CDs. See "ITEM 1-Description of Business-Competition."
HISTORY
The Company was formed in September 1996 to acquire the assets of Compact Discs International, Ltd. ("CDIL"), a Texas limited partnership which franchised stores throughout the United States and England under the name "CD Warehouse." A portion of the proceeds of the Company's IPO was used to fund the $3.2 million acquisition (the "CDIL Acquisition"), which was consummated simultaneously with the closing of the IPO. See Item 12-Certain Relationships and Related Transactions. In a related transaction (the "MacDonald Acquisition"), which also occurred simultaneously with the closing of the IPO, the Company acquired the equity interests of Bruce D. MacDonald (together with his affiliates, "MacDonald") in various partnerships or other entities which were franchisees of an aggregate 36 franchised CD Warehouse stores. See Item 12-Certain Relationships and Related Transactions. As a result of the CDIL Acquisition and the MacDonald Acquisition, the Company acquired the rights to the CD Warehouse name, assumed CDIL's role as franchisor under the franchise agreements to which CDIL was a party and acquired interests in the CD Warehouse stores in which MacDonald had an interest.
RECENT EVENTS
On February 22, 1999, the Company completed the purchase of a 16-store retail music chain located in San Diego, California and surrounding areas and operating under the name "Music Trader." The Company operates the 16 stores as company-owned stores under the CD Warehouse concept. The total purchase price for the transaction, which was structured as an acquisition of the assets relating to the 16 stores, was $4,000,000, comprised of $3,000,000 in cash and $1,000,000 in Common Stock of the Company, valued for purposes of the acquisition at $11.80 per share.
Effective January 4, 2000, Gary D. Johnson resigned his positions as Director, Executive Vice President and Chief Operating Officer of the Company. On March 1, 2000, the Company entered into an agreement with Mr. Johnson to sell to him two company-owned stores, as well as a store "package" (consisting of the furniture, fixtures and inventory necessary to open a CD Warehouse store), for an aggregate purchase price of $425,505 (the "Johnson Sale"). The sale was consummated on March 21, 2000.
BUSINESS STRATEGY
The Company's business strategy of offering a mix of both new and pre-owned CDs is based on its belief that there is a growing consumer willingness to purchase pre-owned CDs, which is providing an expanding market niche in the retail music industry for CD resellers. The Company's business strategy is to establish itself as the recognized industry leader in the domestic buy-sell-trade retail CD marketplace by pursuing a three-fold approach: (1) offering quality, pre-owned CDs at exceptional value; (2) offering to accept as a trade, or buy for cash, selected CDs from customers; and (3) selling new releases at competitive prices.
According to the Recording Industry Association of America (the "RIAA"), annual CD sales in the United States for 1999 were $12.8 billion which represented a 12.3% increase from 1998 domestic CD sales of $11.4 billion. The lack of any audible difference between new and pre-owned CDs, durability of the medium, cost savings and the accumulating stock of available CDs for resale, suggest the possibility for rapid market growth in the pre-owned CD market. Because the CD is encased in plastic and read by a laser, the playing of CDs, and even the occasional careless handling of CDs, rarely cause damage that will impair performance or result in any degradation of sound quality. In the absence of pronounced abuse, CDs may reasonably be expected to last for decades; premium (gold-plated) CDs may last for centuries. Such extraordinary durability, coupled with the standard error-correction circuitry in CD players, means that pre-owned CDs are essentially indistinguishable from new CDs in terms of audible performance. By offering quality pre-owned CDs at substantial savings and responding to consumers' desire to recycle merchandise they no longer want or use but which has intrinsic value, the CD Warehouse remarketing concept emphasizes consumer value.
Management believes that, in addition to the Company, Hastings Entertainment, Inc. and Wherehouse Entertainment, Inc. are the only national chains selling pre-owned CDs on any significant scale. The Company believes that it can increase its market share by expanding the CD Warehouse System in targeted markets. The Company's expansion strategy for 2000 is to open 25 to 30 franchised stores. To accomplish this objective, the Company employs a business strategy that includes the following elements:
INVENTORY MANAGEMENT SYSTEM. The Company considers its inventory management system, which is a software program proprietary to the CD Warehouse concept, to be essential to the success of its business strategy. The program, which has a database in excess of 270,000 titles and includes catalogs from all the major record labels, assists each store in selectively procuring pre-owned CDs by supplying buying directions for every CD offered. The ability to access this data instantly gives store operators the capability to make an informed decision on every CD presented by a customer for purchase or trade, by reviewing the title's historic sales data, as well as the recommended purchase price that the CD has been assigned by the Company. By scanning each CD (utilizing bar coding capability), the program also includes point-of-sale recording of all transactions, including customer profiles with which mailing lists may be created. Additionally, as each transaction is entered, the program provides for the printing of customer receipts which concurrently compiles inventory by title, including respective costs, selling price and gross profit results. Accordingly, the program can generate reports of comprehensive data for any selected period or any facet of store operations, including sales by title, sales by dollar volume, inventory by title, individual transaction summaries, acquisitions for any period, system adjustments, cash register reconciliation and virtually any other pertinent financial information. Disc Go Round stores utilize an inventory and point-of-sale software that offers comparable management reporting capability but lacks the ranking by levels of the CD Warehouse database.
The Company believes that the proprietary inventory management system contributes to more efficient system-wide management of inventory by reducing the need to purchase new titles from music distributors for new store inventories and affording existing stores the opportunity to sell excess inventory. As new stores are developed, opening packages of inventory are assembled by the Company and sold to the franchisees. The demand for inventory by new stores allows existing stores to sell excess inventory. If, for example, it is determined that a store may be overstocked on a particular selection, the Company may purchase the selection and resell it to another unit or as part of the opening inventory of a new store. The Company believes that this is a significant advantage in comparison to its competitors, since the Company can review all titles available and source its own system for inventory. Management anticipates as much as 75% of the opening inventory for a new store can be purchased from system stores. This constant inventory turnover allows existing stores to make a reasonable profit and provide a source of capital while providing an opportunity for the Company to acquire quality inventory to open new stores or update an existing location's inventory.
The Company is finalizing an upgraded version of its proprietary software system. The upgrade is expected to include such enhancements as (i) a communications interface that will allow all stores to communicate with the Company and with each other, and (ii) an accounting package that will produce a profit and loss statement from the information captured by a store's point-of-sale register. The Company expects to introduce the software upgrade to all CD Warehouse stores during 2001.
CUSTOMER SERVICE. The Company emphasizes excellent customer service and seeks to employ, and to sell franchises to, motivated and energetic people. The Company also seeks to foster enthusiasm for its customer service philosophy and its franchise concepts through annual franchise conventions, regional meetings and other frequent contacts with its franchisees and store managers.
TARGETED EXPANSION. The Company believes that its existing core and developing markets offer significant growth opportunity for franchised store development. The Company concentrates its expansion of stores in markets where it can cluster stores, thereby expanding consumer awareness and creating significant operating, distribution and advertising efficiencies. To increase its penetration of core markets, the Company historically has co-developed markets with franchisees, divided markets among franchisees or divided markets among the Company and franchisees, "clustering" both company-owned and franchised stores through the use of area development agreements and its site selection approval process. The Company believes that this approach has contributed to increased average store sales. For 2000, the Company has determined to focus its efforts on market expansion through increased franchised store development, rather than company-store development.
STORE LOCATIONS
The table below shows the location, as of December 31, 1999 of all CD Warehouse and Disc Go Round stores (which also includes, for each franchise system, stores operating under the trade name "CD Exchange" or "Music Trader") in the United States, Canada, England, France, Guatemala and Venezuela:
DOMESTIC - --------
ALABAMA Birmingham++ Daphne++ Homewood++ Hoover++ Huntsville (2)++ Mobile (2)++
ARIZONA Tempe++
ARKANSAS Fayetteville++ Fort Smith++ Little Rock * North Little Rock*
CALIFORNIA Chula Vista* El Cajon* Encinitas* Escondido* Huntington Beach+ Oceanside* Palm Desert+ Poway* San Diego (8)* San Marcos* Santee*
COLORADO Arvada+ Colorado Springs++ Ft. Collins* Littelton+
DELAWARE Newark+ Wilmington+
FLORIDA Coral Gables* Davie++ Daytona Beach* Deland* Fern Park* Ft. Lauderdale (2)++ Ft. Myers++ Gainesville++ Jacksonville (2)* Lake Park++ Melbourne* Miami Lakes* Miami* Naples++ Neptune Beach* North Miami* Orange Park* Orlando* Orlando+ Ormond Beach* Penbrooke Pines++ Port Charlottee++ Sanford* Tallahassee (3)++ Tampa+ Venice++
GEORGIA Atlanta (2)++ Atlanta+ Duluth++ Marietta (2)++ Martinez++ Morrow++
IDAHO Idaho Falls++
ILLINOIS Carbondale++ Chicago (2)+ Harwood Heights+ Moline+ North Riverside+ Streamwood++
INDIANA Bloomington+ Indianapolis++ Indianapolis (3)+ Mishawaka+
IOWA Ames+ Cedar Rapids++ Cedar Rapids+ Clive+ Davenport++ Davenport+ Des Moines (2)++ Des Moines+ Iowa City++ Sioux City++ Waterloo++ Waterloo+
KANSAS Overland Park* Shawnee* Wichita++ Olathe*
KENTUCKY Lexington++ Louisville+ Paducah++
LOUISIANA Baton Rouge* Baton Rouge++ Gretna++ Lafayette* Metarie* New Orleans++ Shreveport++ Shreveport+
MARYLAND Elkridge++ Laurel++
MICHIGAN East Lansing++ Grand Rapids (2)++ Holland+ Kalamazoo++
MINNESOTA Bemidji+ Blaine++ Brooklyn Center++ Burnsville++ Duluth+ Edina++ Maple Grove+ Maplewood++ Minneapolis (2)++ Roseville++ St. Cloud++
MISSOURI Arnold++ Ballwin++ Cape Girardeau++ Gladstone* Independence* Kansas City* Lee Summit* Maryland Heights++ O'Fallon++ Springfield* St. Louis++
MONTANA Bozeman++ Great Falls++
NEBRASKA Lincoln* Omaha*
NEVADA Las Vegas*
NEW JERSEY Belleville++ Freehold+ Laurel Springs++ Northfield++ Voorhees+
NEW YORK Endicott+ Guilderland+ Huntington Station++ Rockville Center++ Wantaugh+ White Plains++
NORTH CAROLINA Cary+ Charlotte (3)++ Durham+ Fayettville++ Goldsboro++ Raleigh+ Wilmington+ Wilson++
NORTH DAKOTA Fargo++
OHIO Beavercreek+ Boardman++ Canton++ Centerville+ Cincinnati(2)+ Cleveland Heights++ Columbus (4)++ Fairlawn++ Holland++ Mayfield Heights++ Mentor++ Miamisburg++ Niles++ Parma Heights++ Toledo++
OKLAHOMA Edmond* Midwest City* Norman* Oklahoma City (3)* Shawnee* Stillwater (2)* Tulsa* Tulsa++
OREGON Beaverton+ Portland+
PENNSYLVANIA Allentown+ Conshohocken+ Easton+ Erie+ Greensburg++ Harrisburg++ Lancaster++ Mechanicsburg++ Monroeville++ Philadelphia+ Pittsburgh (2)++ Pittsburgh+ State College++ West Mifflin++
SOUTH CAROLINA Columbia+ Greenville (2)++
SOUTH DAKOTA Sioux Falls+
TENNESSEE Antioch++ Bartlett+ Clarksville++ Jackson++ Madison++ Memphis* Murfreesboro++ Nashville++
TEXAS Abilene* Addison* Arlington (3)++ Austin (4)++ Carrollton* College Station+ Corpus Christi++ Corpus Christi+ Dallas (7)++ Denton ++ Duncanville++ El Paso* Ft. Worth++ Garland* Grand Prairie++ Houston (6)* Houston+ Hurst++ Irving++ Lewisville++ Longview++ Lubbock++ Mesquite++ Midland* North Richland Hills++ Plano* Round Rock++ San Angelo++ San Antonio (7)++
TEXAS (con't) San Marcos++ Sherman++ Texarkana++ Waco* Webster* Wichita Falls*
UTAH Provo++ Provo+ Salt Lake City++ St. George++ Taylorsville++
VERMONT Burlington+
VIRGINIA Alexandria++ Fairfax++
WASHINGTON Belleville++ Bremerton++ Kennewick+ Linwood+ Seattle++ Seattle(3)+
WISCONSIN Appleton++ Appleton+ Brookfield++ Brookfield+ East Milwaukee+ Green Bay+ Greenfield+ Greenfield++ Janesville+ Kenosha++ Madison(3)+ Madison++ Racine++
DISTICT OF COLUMBIA Washington++
INTERNATIONAL - -------------
CANADA Charlottetown/PE+ Dartmouth/NS+ Halifax/NS+ Kingston/ON++ Ottawa/ON (2) ++ Thunder Bay/ON++ Winnipeg/MB (3)+
ENGLAND Ealing++ Leeds++ London++ Watford++
FRANCE Caen++
GUATEMALA Guatemala City++
VENEZUELA Caracus++
_____________________________ * Indicates company-owned store. ++ Indicates CD Warehouse franchised store. + Indicates Disc Go Round franchised store.
EXPANSION STRATEGY
The first CD Warehouse store opened in Dallas, Texas in August 1992 and, as of December 31, 1999, the CD Warehouse System had an aggregate 339 stores in 39 states and the District of Columbia, Canada, England, France, Guatemala and Venezuela, with 185 franchised stores and 75 company-owned stores operating under the CD Warehouse concept and 79 franchised stores operating under the Disc Go Round concept. Key elements of the Company's expansion strategy include:
AGGRESSIVE, BALANCED GROWTH. Historically, the Company's expansion strategy has been to increase the number of franchised stores by selective utilization of Company-owned stores in a particular market area. The Company believes that, in many cases, the Company has been able to take advantage of a promising new location by establishing a Company-owned store when a delay in finding a qualified franchisee might have jeopardized the Company's ability to secure the site. Company-owned stores also provide a training ground for Company-owned store and district managers and a controllable testing ground for new products and promotions, operating and training methods and merchandising techniques. However, the cornerstone of the Company's expansion strategy remains the addition of new franchised stores in the system, which enables the Company to expand its system more quickly with no capital investment. For 2000, the Company has determined to focus its efforts on market expansion through increased domestic franchised store development, rather than company-store development.
NAME RECOGNITION AND NEW MARKET PENETRATION. The Company believes the visibility of its stores at high traffic, Class A, strip shopping centers has generated good name recognition in the areas in which stores currently are located. The Company's expansion strategy involves the building-out of existing markets and the further penetration of developing markets through clustering of franchised stores. This expansion strategy is designed to take advantage of operational and advertising efficiencies through store clustering within television and other advertising markets, thereby increasing market penetration and consumer awareness. In determining which new markets to develop, the Company considers many factors, including the size of the market, demographics, cost of media, population trends, competition and real estate availability and pricing.
CONSIDERATION OF ACQUISITIONS. During 1999, the most significant factor attributable to the Company's store and revenue growth was the acquisition of Music Trader, Inc., a 16-store retail music chain based in Southern California. The Company may consider acquisition of other local and regional pre-owned music retailers to implement its strategy of building out current markets and establishing itself in new target markets. However, it is the Company's present intention to focus its expansion strategy on domestic franchised store development.
OPERATIONS
ACQUISITION OF PRE-OWNED CDS. A key component of the two franchise concepts within the CD Warehouse System is the purchase or trade of selected CDs from customers; accordingly, the Company obtains a significant portion of its pre-owned CD inventory primarily from within the system itself. Additionally, utilizing its inventory management system, which is a proprietary program, the Company affords existing stores the opportunity to sell excess inventory. As new stores are developed, opening packages of inventory are assembled by the Company and sold to the franchisees. The demand for inventory by new stores allows existing stores to sell excess inventory. If, for example, it is determined that a store may be overstocked on a particular selection, the Company may purchase the selection and resell it as part of the opening inventory of a new store. The Company believes that this is a significant advantage in comparison to its competitors since the Company can review all titles available and source its own system for inventory. As much as 75% of the opening inventory for a new store can be purchased from system stores. This constant inventory turnover allows existing stores to make a reasonable profit and provide a source of capital while providing an opportunity for the Company to acquire quality inventory to open new stores or update an existing location's inventory.
PURCHASING OF NEW CDS, OTHER POINT-OF-SALE ITEMS AND STORE FIXTURES. For new music releases, the Company contracts with outside third-party distributors. The Company negotiates with vendors on behalf of the system for inventory display racks, lighting and related products which are then shipped directly from the manufacturers to the individual stores.
As the system grows, the Company believes that additional quantity discounts can be negotiated with the respective equipment and product suppliers. The Company maintains its own distribution facility to provide its franchised and Company-owned stores with supplies and related materials.
MARKETING AND ADVERTISING
CD WAREHOUSE STORES. The Company provides new stores with certain pre-opening items and point-of-sale materials. Additional point-of-sales materials are available to all stores at no cost from the record companies. Additionally, the CD Warehouse franchise agreements provide for each store to spend 2.5% of sales specifically on advertising, with each CD franchisee conducting its own marketing and advertising activities independently through newspapers and radio. In 1999, the Company activated a mandatory concept-wide advertising fund (the "SAF"). The Company expects that the SAF will become the primary creative and production vehicle for all marketing efforts respecting the CD Warehouse concept.
DISC GO ROUND STORES. Disc Go Round franchisees under existing franchise agreements are required to spend 5% of their gross sales on approved advertising and marketing. In addition, all Disc Go Round franchisees are required to pay the Company an annual advertising production fee of $500.
Under the current form of Disc Go Round franchise agreement, applicable for renewals, Disc Go Round franchisees are required to spend during each calendar quarter 2.5% of the store's gross sales to advertise and promote the store, of which 1 3/4% is spent directly by the store in local market advertising, and 3/4% is paid to the Company to be deposited into a concept-wide advertising fund to market the Disc Go Round concept.
FRANCHISING PROGRAM
CD WAREHOUSE
GENERAL. As of December 31, 1999, there were a total of 174 franchised CD Warehouse stores in 32 states and the District of Columbia, and eleven CD Warehouse stores in Canada, England, France, Guatemala and Venezuela. The Company expects to open 25 to 30 new CD Warehouse franchised stores by the end of 2000. However, there can be no assurance that all of these stores will be opened or that the development schedule set forth in each area development agreement will be achieved. Pursuant to the terms of existing area development agreements, a total of 52 stores are committed to be opened over the next two years.
The CD Warehouse franchise agreement provides the franchisee the right to use or be provided, as the case may be, the Company's trade names, service marks and trademarks; design plans, color schemes, signs and fixtures for store premises; buying and selling guidelines; computerized inventory management system; initial inventory, operations and financial control guidelines; initial management training; and advertising assistance.
FRANCHISE SOURCING AND SELECTION. The majority of new franchises are individuals responding to advertisements in national publications such as Entrepreneur Magazine and The Franchise Handbook. Various publications also publish articles or rankings of top-selling franchises (e.g., in February 1999, Entrepreneur Magazine ranked the Company 20th in its list of 101 fastest-growing franchises and 57th in its 20th Annual Franchise 500), which also elicit inquiries from potential franchisees. Franchisees are approved by the Company on the basis of the applicant's net worth and liquidity, together with an assessment of work ethic and personality compatibility with the Company's operating philosophy.
FRANCHISE MARKETING PROGRAM. The Company's franchise marketing program seeks to attract prospective franchisees with management experience, a minimum level of net worth and strong interest in the retail music business. The Company markets its franchise opportunities by advertising in selected business magazines and franchise-oriented publications. Each inquiry is responded to and an initial determination is made as to the prospect's qualifications to become a CD Warehouse franchisee. Once an inquiry is received, the prospect is mailed the Company's brochure and marketing materials. The inquiry is then followed up on within a period of two weeks.
The Company has established a home page via the Internet (World Wide Web) that will provide detail on the franchise opportunities presented by operating a CD Warehouse store. The Company's homepage can be accessed at HTTP://WWW/CDWI.COM/.
TRAINING AND SUPPORT. The Company's philosophy is one of service and commitment to its system. Each franchise owner/operator and each company store manager is required to complete a comprehensive training program in store operation and management. Topics covered in the training course include the CompanY's philosophy of store operation and management, customer service, merchandising, marketing, pricing, inventory and cost control, record keeping, labor scheduling and personnel management. Training is based on standard operating policies and procedures contained in an operations manual provided to all franchisees, which the franchisee is required to follow by terms of the franchise agreement. Additionally, trainees are provided with a complete orientation to Company operations by meeting with members of the senior management of the Company. Training continues through the opening of the store, where Company field personnel assist and guide the franchisee in all areas of operation.
THE FRANCHISE AGREEMENT; TERMS AND CONDITIONS. The domestic offer and sale of CD Warehouse franchises is made by its Uniform Franchise Offering Circular prepared in accordance with federal and state laws and regulations. States that regulate the sale and operation of franchises require a franchisor to register or file certain notices with the state authorities prior to offering and selling franchises in those states.
Under the current form of domestic franchise agreement, CD Warehouse franchisees generally pay the Company an initial franchise fee of $20,000, royalties equal to 5% of monthly gross sales, an advertising fund fee of 3/4% of monthly gross sales and a one-time software licensing gee of $3,000. Franchisees are generally granted exclusive territory with respect to the operation of CD Warehouse stores only in the immediate vicinity of their stores.
The franchise agreement requires franchisees to purchase from the Company certain proprietary software and the store's initial inventory, and to comply with the Company's procedures of operation, to permit inspections and audits by the
Company and to remodel stores to conform with standards in effect from time to time for the CD Warehouse system. The Company may terminate the franchise agreement upon the failure of the franchisee to comply with the conditions of the agreement and upon the occurrence of certain events, such as insolvency or bankruptcy of the franchisee or the commission by the franchisee of any unlawful or deceptive practice which in the judgment of the Company is likely to adversely affect the CD Warehouse system. The Company's ability to terminate franchise agreements pursuant to such provisions is subject to applicable bankruptcy and state laws and regulations.
The franchise agreement prohibits the transfer or assignment of any interest in a franchise without the prior written consent of the Company. The franchise agreement also gives the Company a right of first refusal to purchase any interest in a franchise if a proposed transfer would result in a change of control of that franchise. The refusal right, if exercised, would allow the Company to purchase the interest proposed to be transferred under the same terms and conditions and for the same price as offered by the proposed transferee.
The term of each franchise agreement is ten years, and franchisees generally have the right to renew for an additional ten-year term with the payment of an amount equal to 20% of the then-existing franchise fee. All of the franchise agreements assigned to the Company in connection with the CDIL Acquisition will expire between 2002 and 2006.
UNIT ECONOMICS. The Company believes that future CD Warehouse stores can be opened for an initial investment of $132,300 to $169,000. The estimated initial investment is comprised of the following:
MINIMUM MAXIMUM ------- ------- Franchise Fee $ 20,000 $ 20,000 Software License Fee 3,000 3,000 Lease & Utility Deposits 1,500 4,000 Leasehold Improvements 18,000 22,000 Contractor 11,000 15,000 Computer Hardware 8,000 12,000 Fixtures and Equipment 17,000 19,500 Initial Inventory 40,000 50,000 Signage 6,000 7,500 Travel & Expense of Training 1,000 1,500 Insurance 500 1,000 Miscellaneous Opening Cost 800 2,000 New Store Marketing & Advertising 500 1,500 Operating Cash on Hand 5,000 10,000 ----- ------ Total $ 132,300 $ 169,000 ======= =======
Management believes that a key indicator of the success of a franchise location is the sales to capitalization ratio. That ratio is defined as the annual sales revenue generated by the business divided by the capitalization costs to open the business. For the year ended December 31, 1999, average unit sales on a comparable basis were $372,000. Based on an average initial estimated capitalization of $150,650, the sales to capitalization ratio to open a new CD Warehouse store is 2.47 to 1.
FRANCHISE FINANCING. Typically, franchisees obtain their own sources of financing and do not require the Company's assistance. However, the Company has established a relationship with GE Capital Business Asset Funding Corporation whereby such company provides financing to qualifying franchisees. Franchisees are not obligated to secure financing from such lender, nor is the Company a party to any such financing ultimately obtained by the franchisee.
DISC GO ROUND
GENERAL. As of December 31, 1999, there were a total of 73 Disc Go Round stores in 26 states and six Disc Go Round stores in Canada. The Company has determined that it will not sell or offer for sale any additional Disc Go Round franchises. While the Company will honor its ongoing obligations as the successor franchisor under the Disc Go Round franchise agreements that it acquired, it intends to encourage the existing Disc Go Round franchisees to become CD Warehouse franchisees and to convert their Disc Go Round stores to CD Warehouse stores.
THE FRANCHISE AGREEMENT; TERMS AND CONDITIONS. The domestic renewal of Disc Go Round franchises is made by a Uniform Franchise Offering Circular prepared in accordance with federal and state laws and regulations.
Generally, the form of franchise agreement under which substantially all of the existing Disc Go Round franchises currently operate provides that Disc Go Round franchisees pay the Company (i) royalties equal to 5% of weekly gross sales, and an annual marketing fee of $500.
Under the form of domestic franchise agreement applicable to renewing Disc Go Round franchisees, franchisees generally will pay the Company a renewal franchise fee of $5,000, and royalties equal to 5% of monthly gross sales. Franchisees are generally granted exclusive territory with respect to the operation of Disc Go Round stores only in the immediate vicinity of their stores.
The Disc Go Round franchise agreement requires franchisees to comply with the Company's procedures of operation, to permit inspections and audits by the Company and to remodel stores to conform with standards in effect from time to time for the Disc Go Round system. The Company may terminate the franchise agreement upon the failure of the franchisee to comply with the conditions of the agreement and upon the occurrence of certain events, such as insolvency or bankruptcy of the franchisee or the commission by the franchisee of any unlawful or deceptive practice which in the judgment of the Company is likely to adversely affect the Disc Go Round system. The Company's ability to terminate franchise agreements pursuant to such provisions is subject to applicable bankruptcy and state laws and regulations.
The franchise agreement prohibits the transfer or assignment of any interest in a franchise without the prior written consent of the Company. The franchise agreement also gives the Company a right of first refusal to purchase any interest in a franchise if a proposed transfer would result in a change of control of that franchise. The refusal right, if exercised, would allow the Company to purchase the interest proposed to be transferred under the same terms and conditions and for the same price as offered by the proposed transferee.
Existing Disc Go Round franchises may be renewed for a renewal term of five years; however, franchisees will not have the right to a subsequent term of renewal. The Company's ability to not renew franchise agreements pursuant to such provision is subject to applicable state laws and regulations.
INTERNATIONAL FRANCHISE OPERATIONS
There are 11 CD Warehouse franchised stores and six Disc Go Round franchised stores currently operating in Canada, England, France, Guatemala and Venezuela. In January 1997, the Company entered into a master franchise agreement (the "Worldwide Area Development Agreement") with Mark E. Kane, the founder of CDIL. The Worldwide Area Development Agreement provided for a period of ten years for development of franchise operations worldwide, excluding the United States, Canada and Mexico, and included a provision which allowed the Company, at its option, to purchase Mr. Kane's interest in any franchised operations developed pursuant to the Worldwide Area Development Agreement. The development schedule under the agreement required that Mr. Kane open 100 stores over the ten-year period. In June 1998, the Company filed an arbitration claim against Mr. Kane, alleging breach of the Worldwide Area Development Agreement and seeking cancellation of the agreement. Pursuant to a settlement agreement between the parties effective March 15, 1999, the Worldwide Area Development Agreement was terminated, with all development rights under such agreement reverting to the Company.
COMPANY STORE PROGRAM
Company-owned stores permit market penetration, or seeding, in the absence of an immediately viable multi-location franchise operator. Company stores provide an opportunity to continually refine the Company's standard store model in order to respond to market dynamics. Variations in inventory mix, ancillary product offerings, and marketing and sales techniques can be tested and refined before implementation throughout the system.
Managers of Company-owned stores are required to comply with all Company operating standards and undergo training and receive support from the Company similar to the training and support provided to franchisees. See Item 1-Description of Business. The Company's Director of Company Store Operations and his staff regularly visit company-owned stores to ensure compliance with Company standards and procedures and to provide advice and support.
The following table sets forth the number of stores opened and closed throughout the CD Warehouse System during fiscal 1999:
GOVERNMENTAL REGULATION
The Company is subject to various federal, state and local laws affecting its business. Each of the Company's stores is subject to licensing and regulation by a number of governmental authorities, which include taxing, zoning and building agencies in the state or municipality in which the store is located. Difficulties in obtaining or failures to obtain required licenses or approvals could delay or prevent the opening a new store in a particular area.
The Company is subject to Federal Trade Commission ("FTC") regulation and various state laws that regulate the offer and sale of franchises. The FTC has adopted a rule that requires franchisors to make certain disclosures to prospective franchise owners prior to the offer or sale of franchises. This rule requires the disclosure of information necessary for a franchise owner to make an informed decision as to whether to enter into a franchise relationship and delineates the circumstances in which franchisors may make predictions on future sales, income and profits. Failure to comply with this rule constitutes an unfair or deceptive act or practice under the Federal Trade Commission Act. Additionally, numerous states have in recent years adopted laws regulating franchise operations and the franchisor-franchisee relationship, and similar legislation is pending in Congress and several other states. Existing laws and pending proposals vary from filing and disclosure requirements in the offer and sale of franchises to the application of statutory standards regulating the establishment and termination of franchise relationships. These laws generally apply to both area and individual franchises. Although the foregoing matters may result in some modification in the Company's franchising activities and some delays or failures in enforcing certain of its rights and remedies under certain area or individual franchise agreements, such modifications, delays or failures have not had a material adverse effect on the Company's operations or business. However, the law applicable to franchise operations and relationships is still developing, and the Company is unable to predict the effect, if any, on its operations of additional requirements or restrictions that may be enacted or promulgated or of court decisions that may be adverse to the franchise industry. While it is difficult to assess potential effects of federal and state legislation in the U.S. or new international laws that may impact the industry, the Company does not anticipate any material adverse effects from such legislation or laws at this time.
The Company's operations are also subject to federal and state laws governing such matters as wages, working conditions and overtime.
COMPETITION
The Company competes in the retail music industry, which is highly competitive in price, selection, service and location and is often affected by changes in consumer trends, economic conditions, demographics, traffic patterns and technological innovations. The following profile provides an overview and comparison of how the retail "new release" CD industry and the emerging retail "remarketing" or "buy-sell-trade" CD industry are currently structured and segmented.
According to the RIAA, CD sales in the United States were over $12.8 billion in 1999. The Company has various competitors in the industry that sell new recordings and music related merchandise. These companies vary from those who are specialty music stores in malls (such as Sam Goody's and Camelot), those who utilize freestanding buildings (such as Wherehouse Entertainment, Inc. and Hastings Entertainment, Inc.) and those who sell via the Internet (such as CDNow and Amazon.com). Empirical studies conducted by the Company indicate that companies in mall locations typically charge $15.99 to $17.99 for their front-line CD products. Those in freestanding buildings generally have much larger facilities (between 12,000 to 20,000 square feet). Their selling price for front-line items range between $13.99 and $17.99, with the latest top 20 releases on sale for $11.99 to $13.99 per CD. None of these "superstores" sell pre-owned music except for Wherehouse Entertainment, Inc. and Hastings Entertainment, Inc.
Other retailers offering music include major national discount stores, including Wal-Mart, K-Mart and Target stores. These national discounters maintain a very small number of new music titles while offering no pre-owned music. Their pricing will typically vary from $11.99 to $13.99 per item in approximately 1,000 square feet of space. In another category are the multi-media electronic stores (such as Best Buy and Circuit City), which have generally utilized approximately 1,000 square feet of space and discount their new releases from $12.99 to $17.99 per item.
Other competitors include specialty Internet retailers such as CDNow, and more general Internet retailers, such as Amazon.com, which have targeted the prerecorded music market. In response to this growth in electronic commerce and the future potential for on-line sales of prerecorded music product, the Company launched its own Internet commerce site, HTTP://WWW.CDWAREHOUSE.COM, in December 1998. The website, which experienced initial difficulties in uploading the used inventory of company-owned stores, became fully operational in August 1999, and now offers both new and used product. Additionally, the Company anticipates that the website will also be available for participation by franchised stores in 2000. The Company believes that its ability to offer hard to find, out of print product, will provide it with a competitive advantage over other Internet retailers of prerecorded music. However, the e-commerce market is new, rapidly evolving and intensely competitive, and the Company expects that competition will further intensify in the future. Barriers to entry are minimal, and current and new competitors can launch new sites at a relatively low cost.
The Company believes that CD Warehouse stores compete favorably with its competition in the pre-owned CD market in terms of price, selection, service and location.
In selling franchises, the Company also competes with many franchisors of retail and other business opportunities.
TRADEMARKS AND SERVICE MARKS
The names "CD Warehouse," "Disc Go Round," and "CD Exchange" are registered with the United States Patent and Trademark Office. The Company also has registered its copyright on its proprietary software system and has made application for the service marks for the phrases "The Future of Music" and "A New Spin on Music." The Company believes that its trademarks, service marks and copyright have significant value and are important to its marketing efforts.
EMPLOYEES
The Company as of March 10, 2000 employs 285 full-time and 150 part-time employees. None of the Company's employees are represented by a labor union and the Company believes that its relations with its employees are good.
