Historically, our business has focused on providing distribution services for third party vendors. Over the past three years, we have expanded our business to include the licensing and publishing of home entertainment and multimedia content, primarily through our acquisitions of publishers in select markets. By expanding our product offerings through such acquisitions, we believe that we can leverage both our sales experience and distribution capabilities to drive increased retail penetration and more effective distribution of such products, and enable content developers and publishers that we acquire to focus more on their core competencies.
Our business is divided into three segments—Distribution, Publishing and Other.
Distribution. Through our distribution business, we distribute and provide fulfillment services in connection with a variety of finished goods that are provided by our vendors, which include PC software and video game publishers and developers, independent and major music labels, and independent and major motion picture studios. These vendors provide us with PC software, CD audio, DVD video, and video games and accessories which we, in turn, distribute to our retail customers. Our distribution business focuses on providing vendors and retailers with a range of value-added services including: vendor-managed inventory, Internet-based ordering, electronic data interchange services, fulfillment services and retailer-oriented marketing services. Our vendors include Symantec Corporation, Adobe Systems, Inc., McAfee, Inc., and Dreamcatcher Interactive, Inc. Our digital strategy consists primarily of the sale of independent music titles through online digital music retailers such as iTunes, Napster and Rhapsody. The Company also continues to explore additional digital distribution opportunities for our other product categories.
Publishing . Through our publishing business, which generally has higher gross margins than our distribution business, we own or license various PC software, CD audio and DVD video titles, and we package, brand, market and sell directly to retailers, third party distributors and our distribution business. Our publishing business currently consists of Encore Software, Inc. (“Encore”), BCI Eclipse Company, LLC (“BCI”), FUNimation Productions, Ltd. and The FUNimation Store, Ltd. (together, “FUNimation”). Encore, which we acquired in July 2002, licenses and publishes personal productivity, genealogy, education and interactive gaming PC products, including titles such as Print Shop, Print Master, PC Tool’s Spyware Doctor and Hoyle PC Gaming products . BCI, which we acquired in November 2003, is a provider of niche DVD and video products such as He-man and the Masters of the Universe and in-house produced CDs and DVDs. FUNimation, acquired on May 11, 2005, is a leading anim e content provider in the United States and licenses and publishes titles such as Dragon Ball Z, Fullmetal Alchemist, Code Lyoko, Samari Seven, Burst Angel, Noddy, Yu Yu Hakusho and Degrassi.
Other . The other segment consists of a variable interest entity (“VIE”), Mix & Burn, Inc. (“Mix & Burn”), included in our consolidated results during the period commencing December 31, 2003, and ending December 31, 2005, in accordance with the provisions of FIN 46(R). Mix & Burn designs and markets digital music delivery services for music and other specialty retailers. During the three months ended December 31, 2005, the Company deconsolidated Mix & Burn, as the Company was no longer deemed to be the primary beneficiary of this VIE.
Strategy
We seek to continue to grow our distribution and publishing businesses, through a combination of organic growth and targeted acquisitions, intended to leverage the complementary strengths of our businesses. We intend to execute this strategy as follows:
• Acquisitions of Attractive Content. We seek to continue to expand our publishing business through the acquisition or licensing of well-established titles or other attractive content. We believe these acquisitions and/or licenses will help position us to increase our net sales in our publishing business, which historically has had higher margins than our distribution business, and will allow us to distribute additional home entertainment and multimedia content through our distribution business. In addition,
we believe that by allowing the management of these publishing companies to focus on content licensing and marketing rather than on distribution operations, they will be able to devote more time and greater resources to their core competency, publishing. We believe that leveraging the core assets and strengths of our distribution business will provide broader retail penetration, distribution expertise and other services for our content and increase sales of our publishing products. We may also seek selective acquisitions of distribution businesses.
| • | Distribute a Broader Range and Larger Volume of Products. We seek to distribute a broader range and larger volume of home entertainment and multimedia products to our retail customers by providing a broad selection of products and capitalizing on our customer relationships. We seek to capture additional business from new and existing retail customers by providing them with a lower “all-in” cost of procuring merchandise and getting product to retailers’ shelves through efficient distribution. We expect that providing additional products to retailers will enable us to gain category management opportunities and enhance our reputation for product distribution expertise. We believe our strategic account associates located throughout the United States and Canada will help position us to improve the retail penetration of our published products to new and existing retail customers. | ||
| • | Integrating Our Technology and Systems with Retailers. We seek to enhance the link in the supply chain between us and our publishers and retail customers through the integration of our respective information and technology systems, including inventory management tools, replenishment systems and point-of-sale information. We believe this integration will lead to better in-stock levels of product, improved on-time arrivals of product to the customer, enhanced inventory management and lower return rates for our customers, thereby strengthening customer relationships. | ||
| • | Providing Value-Added Services. We believe that due to increasing retailer logistic needs and demands, including demands for new technology standards such as GTIN® (global trade item number), RFID (radio frequency identification devices) and VMI (vendor managed inventory), many publishers will be required to decide whether to spend additional resources to update their distribution capabilities or to select a distributor such as us that intends to offer such services. We believe that implementing and offering these and other technologies should position us well to capture additional business from existing and new publishers. |
Our overall goal is to create a structure that leverages the complementary strengths of our businesses: publishing, which provides brand management and marketing, licensing, and home video sales; and distribution, which provides enhanced distribution, logistics and customer relations.
Competitive Strengths
We believe that we possess the following competitive strengths:
| • | Value-Added Services. We offer a wide range of distribution services and procurement solutions intended to capitalize on our broad understanding of the products that we distribute, the procurement process and the supply chain, as well as our logistics expertise and systems capabilities. We believe that our advanced distribution infrastructure enables us to provide customized procurement programs for our retail customers at a lower overall cost than many of our competitors. In addition, we believe that our information technology systems provide cost-effective interfacing with our customers’ information technology systems, supporting integration of the procurement process. We believe that our focus on providing customer-specific and cost-effective solutions is a key benefit that we provide to our retail customers. | ||
| • | Broad Product Offering. We provide our retail customers with a broad selection of home entertainment and multimedia products that we believe allows us to better serve their home entertainment and multimedia product requirements. In addition, we regularly survey the markets we serve for new products with significant retail potential, that come from publishers we currently have relationships with as well as those we have not distributed for in the past. | ||
| • | Established Content in our Publishing Business. We currently license a number of well-known home entertainment and multimedia titles. Encore publishes leading titles in the education, productivity, kids and games software categories, including Print Shop, Print Master, PC Tool’s Spyware Doctor, and Hoyle PC Gaming Products. In addition, our BCI subsidiary currently publishes home video for He-man and the Masters of the Universe, the television shows Rides and Overhaulin’, both featured on The Learning Channel, and PRIDE Fighting Championships, featured on Pay-Per-View. Through our FUNimation business we also license and distribute a portfolio of established anime and children’s entertainment titles in the United States, including Dragon Ball Z, Fullmetal Alchemist, Code Lyoko, Samari Seven, Burst Angel, Noddy, Yu Yu Hakusho and Degrassi. |
| • | Established Relationships with Publishers and Retailers. Since our founding in 1983, we have established distribution relationships with major retailers including Best Buy, Wal-Mart/Sam’s Club and CompUSA, and we currently distribute to over 19,000 retail and distribution center locations throughout the United States and Canada. We believe our strong relationships throughout the supply chain, broad product offering and our distribution facility permit us to offer industry-leading home entertainment and multimedia products to our retail customers and provide access to attractive retail channels for publishers of these products. We believe our relationships with leading publishers and our efficient distribution of their products should provide opportunities for us to secure distribution rights to leading products in the future. We believe that these relationships give us a competitive advantage in the markets in which we operate and provide us with attractive channels to distribute current and future products offered by our publishing business. | ||
| • | Efficient Operations and Operating Leverage. We believe that our competitive position is enhanced by our efficient operations, which are based on extensive use of automation and technology in our distribution facility; centralization of functions such as purchasing, accounting and information systems; and economies of scale. Our warehouse facility adjacent to our corporate headquarters provides us with the ability to efficiently service our vendors and retail customers, and the capacity to increase the number of products that we distribute. |
Distribution Markets
PC Software
According to The NPD Group, the PC software industry achieved $3.8 billion on a trailing 12 month basis ending December 31, 2005. Categories that experienced an increase during this time period were business and finance products.
We presently have relationships with PC software publishers such as Symantec Corporation, Roxio, Inc., Adobe Systems Inc., McAfee, Inc., Dreamcatcher Interactive, Inc., Delorme, Webroot Software, Inc. and Lucas Arts Entertainment. These relationships are important to our distribution business and during the fiscal year ended March 31, 2006 each of these publishers accounted for more than $5.0 million in revenues. In the case of Symantec, sales accounted for approximately $86.9 million in net sales in the fiscal year ended March 31, 2006 and $90.8 million in net sales for the fiscal year ended March 31, 2005. During the past fiscal year, we added several publishers to our distribution roster.
While we have agreements in place with our major suppliers, they are generally short-term agreements with terms of one to three years, they generally cover the right to distribute in the United States and Canada, they do not restrict the publisher from distributing their products through other distributors or directly to retailers and they do not guarantee product availability to us for distribution. Our agreements with these publishers provide us with the ability to purchase products at a reduced wholesale price and for us to provide a variety of distribution and fulfillment services in connection with the products. We intend to continue seeking to add publishers to attempt to further increase our market share in the PC software industry.
Video Games Software and Accessories
According to The NPD Group, the video games software and accessories industry was $10.5 billion in 2005 compared to $10.0 billion in 2004. According to industry sources, the installed base of video game consoles in North America is expected to grow to approximately 159.3 million users in 2010 compared to 97.1 million users in December 2005.
We continued to expand our distribution of console-based video games in fiscal 2006. Our relationships with video game vendors such as Square Enix USA, Inc., Midway, THQ and Vivendi are important to this category of our distribution business.
Major Label Music
The Company distributed CD’s on behalf of major labels to a few select retailers. Generally, major music labels control distribution of their products through major music retail chains and other channels. During fiscal 2006, we exited the major label music category to focus our resources on other product categories.
Independent Label Music
The independent segment of the music industry currently represents approximately 13% of total music product for 2005 according to the Recording Industry Association of America (“RIAA”).
We are one of a limited number of large, independent distribution companies that represent independent labels exclusively on a regional or national basis. These companies provide products and services to the nation’s leading music specialty stores and wholesalers. We seek to increase our market share in the independent music distribution business by continuing to seek quality music labels and to provide greater service to our customers, in addition to providing content ownership and licensing opportunities. Relationships with independent music labels such as CMH Records, Inc., Dualtone Music Group, Inc., Equity Records, Inc. and Cleopatra Records, Inc. are also important to our independent music distribution business. We have exclusive distribution agreements in place with certain of these labels that allow us to retain a percentage of amounts received in connection with the sale of the products provided by these labels. Among other customary provisions, these agreements generally provide us with the ability to return products to our independent music labels, the right for us to retain a reserve against potential returns of products, and requirements that the label provide discounts, rebates and price protections.
Major Studio Home Video
According to industry sources, U.S. home video industry sales totaled $24.3 billion in 2005 compared to $24.5 billion in 2004.
Our relationships with Universal Distribution Corp., Twentieth Century Fox Home Entertainment and Buena Vista Home Video are important to our major studio home video distribution business.
Customers
Since our founding in 1983, we have established relationships with retailers across mass merchant, specialty and wholesale club channels, including Best Buy, Wal-Mart/Sam’s Club, CompUSA and Costco. We currently sell and distribute products to over 19,000 retail and distribution center locations throughout the United States and Canada. While a major portion of our revenues are generated from these major retailers, we also supply products to smaller independent retailers as well as through telephone sales and our business-to-business site located at www.navarre.com . See “E-Commerce”. Through these sales channels, we seek to ensure a broad reach of product throughout the country in a cost-efficient manner.
In each of the past several years, we have had a small number of customers that accounted for 10% or more of our net sales. During the fiscal year ended March 31, 2006, sales to two customers, Best Buy and Wal-Mart/Sam’s Club, accounted for approximately 18%, and 12%, respectively, of our total net sales. During the fiscal year ended March 31, 2005, sales to these customers represented approximately 19% and 20%, respectively, of our total net sales.
Navarre’s Distribution Business Model
Vendor Relationships
We view our vendors as customers and work to manage retail relationships to make their business easier and more productive. By doing so, we believe that our reputation as a service-oriented organization has helped us expand our vendor roster. We believe that major companies like Adobe Systems, Symantec Corporation, Buena Vista, Universal, Lucas Arts, Konami and Square Enix have been added to our vendor roster because of our reputation as a service-driven organization.
Furthermore, our dedication to smaller, second-tier vendors has helped to complement our vendor roster. Many of these vendors do not have the leverage necessary to manage their business effectively with major retailers. We provide these vendors the opportunity to access shelf space and assist in the solicitation, logistics, promotion and management of products. We also conduct one-on-one meetings with smaller vendors to give them the opportunity to establish crucial business relationships with our retail customers. Examples of these vendors are as follows: Dreamcatcher Interactive, Inc., First Look Home Entertainment, Hart Sharp Video, Intec Inc. and Majesco.
Retail Services
Along with the value added sales functions that we provide to vendors, we also have the ability to customize shipments to each individual customer. In the case of the warehouse club channel, we may “pre-sticker” multiple different labels, based on the vendor/customer preference. We assemble creative marketing programs, which include pallet programs, product bundles and
specialized packaging. We also create multi-vendor assortments for the club channel, providing the retailer with a broad assortment of products. Our marketing and creative services department designs and produces a variety of advertising vehicles including in-store flyers, direct mail pieces and magazine/newspaper ads, as well as free standing displayers for retail.
We are committed to offering first-rate information flow for all vendors. We understand the importance of sharing sell-through, inventory, sales forecasts, promotional forecasts, SKU status and all SKU data with the respective vendor. We provide the aforementioned information via a secure online portal, for vendors. Furthermore, each individual account manager has account-specific information that is shared on a regular basis with appropriate vendors. We also accommodate specialized reporting requests for our vendors, which we believe helps in the management of their business.
Warehouse Systems
A primary focus of our distribution business is logistics and supply chain management. As customer demands become more sophisticated, we have continued to update our technology. In fiscal 2005, we made a significant investment in a new, highly-automated material handling facility which we believe will improve our overall long-term efficiency and assist in reducing costs for both vendors and customers. With our returns processing system, we seek to process returns and issue both credit and vendor deductions within 48 hours of receipt. We believe that our inventory system offers better in-stock levels of product, improved on-time arrivals of product to the customer, enhanced inventory management and lower return rates for our customers, thereby strengthening our customer relationships.
E-Commerce
During fiscal year 2006, we continued to expand the number of electronic commerce (“e-commerce”) customers for whom we perform fulfillment and distribution. These services include sales of PC software, prerecorded music and DVD videos and video games. Our business-to-business web-site www.navarre.com integrates on-line ordering and deployment of text and visual product information, and has been enhanced to allow for easier user navigation and ordering.
Publishing Markets
In July 2002 and November 2003, we acquired Encore and BCI, respectively. Encore is a publisher of PC products and BCI is a provider of niche DVD/video and audio products. Both of these businesses exclusively own or license and produce PC/DVD/video products. Encore has an exclusive co-publishing agreement with Riverdeep, Inc. (“Riverdeep”) for the sales and marketing of Riverdeep’s interactive products in the educational and productivity markets, which includes products published under the Broderbund and The Learning Company labels. Encore also has exclusive licensing agreements with Vivendi and The United States Playing Card Company, Inc. for the sales and marketing of the Hoyle brand of family entertainment software products. FUNimation, acquired on May 11, 2005, is a leading anime content provider in the United States.
Encore
Encore publishes leading titles in the education, productivity, kids and games software categories, including Print Shop, Print Master, PC Tool’s Spyware Doctor and Hoyle PC Gaming products. According to the NPD Group, Encore’s published brands, when combined, rank as the sixth largest PC Software publisher in North America, by dollar sales. According to The NPD Group, for the twelve months ended March 31, 2006, the Hoyle brand held a 12.0% share of the PC Games category based on units sold, and Hoyle Card Games held the #1 rank in this category.
Encore focuses on retail sales and marketing of its licensed content, without the distraction and financial risk of significant content development. The benefit to our licensed vendors is they can focus on their core competencies of content development and delivery.
Encore continues to evaluate emerging PC software brands that have the potential to become successful franchises. Encore continues to focus on establishing relationships with developed brands that are seeking to change their business models.
Encore’s strategy is to continue to license quality branded PC software titles. It has experience in signing single-brand products as well as taking on multiple titles in single agreements, as demonstrated by the signing of the Riverdeep and Hoyle publishing agreements.
Encore’s corporate headquarters are located in Los Angeles, California. Encore’s distribution, assembly and fulfillment operations relocated from Los Angeles, California, to Minneapolis, Minnesota, in January 2005.
BCI
BCI is a developer, licensor, packager and marketer of entertainment video and audio products. Since 1988, BCI has sought to redefine the standards and concepts in the budget DVD category. We believe that BCI was among one of the first vendors to introduce five-pack, ten-pack and 20-pack DVDs to the marketplace. We also believe that BCI was one of the first to introduce “dollar” DVDs to the “dollar store” marketplace.
BCI’s portfolio of titles represents both licensed titles, in-house produced CDs and DVDs from production groups, and specialty television programming. BCI’s home video titles include He-Man and the Masters of the Universe, Rides and Overhaulin’ , featured on The Learning Channel, and PRIDE Fighting Championships, featured on Pay-Per-View.
FUNimation
On May 11, 2005, we completed the acquisition of 100% of the general and limited partnership interests of FUNimation Productions, Ltd. and The FUNimation Store, Ltd., which are based in Fort Worth, Texas (together, “FUNimation”). FUNimation is a leading content provider in the United States market for anime which it licenses from Japanese rights holders and translates and adapts the content for television programming and home videos, primarily targeting audiences between the ages of 6 and 17. In addition, FUNimation licenses other children’s entertainment content. FUNimation leverages its licensed content into various revenue streams, including television broadcast, DVD home video distribution, and licensing of merchandising rights for toys, video games and trading cards. FUNimation’s licensed titles include Dragon Ball Z, Fullmetal Alchemist, Code Lyoko, Samurai Seven, Burst Angel, Noddy, Yu Yu Hakusho and Degrassi .
FUNimation identifies, based on its own market research, properties that it believes can be successfully adapted to the U.S. anime and children’s content market. This market research generally involves analyzing television ratings, merchandise sales trends, home video sales, anime magazines and popularity polls in both the U.S. and Japanese markets. After identifying a property that has the potential for success in the United States, FUNimation seeks to capitalize on its relationships with Japanese rights holders and its reputation as a content provider of anime in the United States to obtain the commercial rights to such property, primarily for television programming, home video distribution and merchandising.
Broadcast . For television programming, FUNimation translates and adapts its licensed anime titles to conform to U.S. television programming standards. FUNimation performs most of its production work in-house at its production facility in Fort Worth, Texas.
Home Video Distribution . FUNimation seeks to increase the revenue derived from its licensed properties through home video distribution. FUNimation also currently provides home video distribution services for other children’s content providers, including 4Kids Entertainment, Nelvana and Alliance Atlantis. A majority of its home videos are sold directly to major retail chains. According to Nielsen VideoScan, in 2005, FUNimation was ranked as one of the leading distributors of anime home video in the United States.
Licensing and Merchandising . For properties which FUNimation controls the merchandise rights, it seeks to further leverage its licensed content by sub-licensing these rights to manufacturers of children’s and other products. FUNimation has developed a network of over 80 license partners, including JAKKS Pacific, Atari, ODM, SCORE Entertainment and Scholastic for the merchandising of toys, video games, apparel, trading and collectible card games and books. FUNimation manages its properties for consistent and accurate portrayal throughout the marketplace. FUNimation receives royalties from its sublicensees based on a predetermined royalty rate, subject to guaranteed minimums in certain cases.
Retail Sales and Web Sites . FUNimation operates websites devoted to the anime fan base. Typically, as part of its brand management strategy, FUNimation will develop an interactive site for each licensed property. These sites provide information about upcoming episodes and the characters associated with the show. In addition, FUNimation’s properties are supported by its in-house Internet store, the Z-Store, which sells home videos and licensed merchandise.
Competition
All aspects of our business are highly competitive. Our competitors include other national and regional businesses, as well as some suppliers that sell directly to retailers. Certain of these competitors have substantially greater financial and other resources than we do. Our ability to effectively compete in the future depends upon a number of factors, including our ability to:
| • | obtain exclusive national distribution contracts and licenses with independent music labels and manufacturers; | ||
| • | obtain proprietary publishing rights with various rights holders and brand owners; | ||
| • | maintain our margins and volume; | ||
| • | expand our sales through a varied range of products and personalized services; | ||
| • | anticipate changes in the marketplace including technological developments and consumer interest in our proprietary products; and | ||
| • | maintain operating expenses at an appropriate level. |
In the PC software industry, we face competition from a number of distributors including Ingram Micro, Inc., Tech Data Corporation and Atari, Inc., as well as from manufacturers and publishers that sell directly to retailers. In the pre-recorded music industry, we face competition from the major label distribution companies, as well as other national independent distributors, such as Koch Entertainment, RED Music Distribution, Alternative Distribution Alliance, Ryko Distribution, Fontana Distribution and Caroline Distribution, as well as from other entities that sell directly to retailers. FUNimation’s competitors include: 4Kids, ADV Films, Geneon Entertainment, Bandai, Ventura, Media Blasters and Buena Vista.
We believe that competition in all of our businesses will remain intense. The keys to our growth and profitability include: (i) customer service, (ii) continued focus on improvements and operating efficiencies, (iii) the ability to license and develop proprietary products, and (iv) the ability to attract new content, quality labels, studios and software publishers. We also believe that over the next several years, the PC software distribution industry and pre-recorded music distribution industry, will continue to further consolidate.
Backlog
Because a substantial portion of our products are shipped in response to orders, we do not maintain any significant backlog.
Environmental Matters
We do not anticipate any material effect on our capital expenditures, earnings or competitive position due to compliance with government regulations involving environmental matters.
Employees
As of March 31, 2006, we had 780 employees, including 206 in administration, finance, merchandising and licensing, 127 in sales and marketing and 447 in production and distribution. These employees are not subject to collective bargaining agreements and are not represented by unions. We consider our relations with our employees to be good.
Capital Resources — Financing
Our credit agreement with GE Commercial Finance was amended and restated in its entirety on May 11, 2005 in order to provide us with the funds necessary to complete funding for the FUNimation acquisition and was again amended and restated in its entirety on June 1, 2005. The credit agreement currently provides a six-year $115.0 million Term Loan B sub-facility, a $25.0 million five and one-half year Term Loan C sub-facility, and a five-year revolving sub-facility for up to $25.0 million. On the Term Loan B sub-facility, 80.1 million was outstanding at March 31, 2006. The Term Loan C sub-facility was paid in full during fiscal 2006. The revolving sub-facility of up to $25.0 million is available to us for our working capital and general corporate needs. There were no amounts outstanding at March 31, 2006 on the revolving sub-facility. See further discussion in Management’s Discussion & Analysis of Financial Condition, Results of Operations and Liquidity and Capital Resources.
The loans under our senior credit facilities are variable rate obligations and are guaranteed by our subsidiaries and are secured by a first priority security interest in all of our assets and in all of the assets of our subsidiary companies, as well as the capital stock of our subsidiary companies.
Under the credit agreement we are required to meet certain financial and non-financial covenants. The financial covenants include a variety of financial metrics that are used to determine our overall financial stability and include limitations on our capital expenditures, a minimum ratio of EBITDA to fixed charges, and a maximum of indebtedness to EBITDA. However, the revolving sub-facility has no borrowing base availability requirement.
Available Information
We also make available, free of charge through our website, www.navarre.com , annual, quarterly and current reports (and amendments thereto) as soon as reasonably practicable after our electronic filing.
Executive Officers of the Company
The following table sets forth our executive officers of Navarre as of June 14, 2006:
| Name | Age | Position | ||
Eric H. Paulson |
61 | Chairman of the Board and Chief Executive Officer | ||
Cary L. Deacon |
54 | President and Chief Operating Officer | ||
J. Reid Porter |
57 | Executive Vice President, Chief Financial Officer | ||
Brian M.T. Burke |
35 | President of Navarre Distribution Services | ||
Michael A. Bell |
41 | Chief Executive Officer of Encore | ||
Gen Fukunaga |
45 | Chief Executive Officer and President of FUNimation | ||
Edward D. Goetz |
62 | President of BCI Eclipse | ||
John Turner |
52 | Senior Vice President of Global Logistics | ||
Ryan F. Urness |
34 | General Counsel and Secretary |
Eric H. Paulson is our founder and has been our Chief Executive Officer since our inception in 1983. Prior to 1983, Mr. Paulson served as Senior Vice President and General Manager of Pickwick Distribution Companies, a distributor of home entertainment products. Mr. Paulson has been a director since 1983 except for the period January 1990 through October 1991 when Navarre was owned by Live Entertainment, Inc.
Cary L. Deacon has been President and Chief Operating Officer of Navarre Corporation since August of 2005, and until that time was the Chief Operating Officer, Publishing and Corporate Relations Officer since joining the Company in September 2002. From September 2001 to August 2002, Mr. Deacon served as President and Chief Executive Officer of NetRadio Corporation, a media company. From July 2000 to August 2001, he served as President, Chief Operating Officer and as a member of the Board of Directors of SkyMall, Inc., an integrated specialty retailer. From August 1998 to July 2000, Mr. Deacon served as President of ValueVision International, Inc., a home-shopping network company. From May 1997 to June 1998, Mr. Deacon served as a General Partner of Marketing Advocates Inc., a marketing consulting firm. Previously, he served as SVP, EVP and COO levels with the Hudson’s Bay Company, Montgomery Wards, Saffer Advertising and Macy’s. Mr. Deacon also serves as a director of Raindance Communication, Inc. (RNDC), which provides remote communications services for business meetings and events.
J. Reid Porter has been Executive Vice President and Chief Financial Officer since joining our Company in December 2005. From October 2001 to October 2004, Mr. Porter, served as Executive Vice President and Chief Financial Officer of IMC Global Inc., a leading producer and marketer of concentrated phosphate and potash for the agricultural industry. During his tenure at IMC Global he helped lead efforts to consolidate the agricultural nutrient industry, culminating in the October 2004 merger of IMC Global with a subsidiary of Cargill Corporation, to form what is now known as Mosaic Global Holdings Inc. From 1998 to October 2001, Mr. Porter served as Vice President and partner of Hidden Creek Industries and Chief Financial Officer of Heavy Duty Holdings, partnerships in the automotive-related and heavy-duty commercial vehicle industries, respectively. Previously, he held executive positions at Andersen Windows, Onan Corporation and McGraw-Edison Company, Inc.
Brian M. T. Burke has been President of Navarre Distribution Services since August 2005. He previously served as Chief Operating Officer, Distribution, since February 2004, Senior Vice President and General Manager, Navarre Distribution Services since April 2001, Vice President and General Manager, Computer Products Division since July 2000 and Vice President, Computer Products Division since October 1999. Prior to that, Mr. Burke held a series of positions of increasing responsibility in Navarre Computer Products Division since joining the Company in July 1995. Previously, Mr. Burke held various marketing, sales and account manager positions with Imtron and Blue Cross/Blue Shield of Minnesota.
Michael A. Bell is the Chief Executive Officer of Encore and has served the Company in that role since August 2002 when Encore, was acquired and became a subsidiary of the Company. Mr. Bell co-founded the acquired company, Encore Software, Inc., in October 1994 and served as its Chief Executive Officer from its founding. Prior to starting Encore Software, Inc., Mr. Bell served as Director of Sales for Paramount from 1992 to 1994. Previously, Mr. Bell served as Sales Manager for NEC, leading an entrepreneurial unit established to forge strategic relationships that helped create the then-nascent CD-ROM industry.
Gen Fukunaga is the Chief Executive Officer and President of FUNimation Productions, Ltd., and has served in that role since May 2005 when FUNimation was acquired by the Company. Mr. Fukunaga co-founded FUNimation in 1994 and has served as its President from its founding. Prior to starting FUNimation, Mr. Fukunaga served as Product Manager of Software Development Tools for Tandem Computers. Previously, Mr. Fukunaga held a strategic consulting position with Andersen Consulting.
Edward D. Goetz has been President of the Company’s subsidiary, BCI Eclipse, since the Company acquired the assets of BCI Eclipse, LLC in November of 2003. Mr. Goetz had also served as the President of BCI Eclipse, LLC since he joined that firm in June of 2000. Prior to joining BCI, he served as the President of Simitar Entertainment from 1984 to 2000. Previously, Mr. Goetz held various positions including National Sales Manager and VP of Media Purchasing at K-Tel International from 1974 to 1984.
John Turner has been Senior Vice President of Global Logistics since September 2003. He previously served as Senior Vice President of Operations since December 2001, and Vice President of Operations since joining the Company in September 1995. Prior to joining Navarre, Mr. Turner was Senior Director of Distribution for Nordic Track in Chaska, MN from July 1993 to September 1995. Previously, he held various positions in logistics in the United States and in the United Kingdom.
Ryan F. Urness has been General Counsel of Navarre since July 2004 and Secretary of Navarre since May 2004. He previously served as Assistant Secretary of Navarre since February 2004 and as Corporate Counsel since January 2003. Prior to joining Navarre a significant portion of Mr. Urness’ efforts were engaged in various matters for the Company as outside legal counsel in the Minneapolis, Minnesota office of Winthrop & Weinstine, P.A. Mr. Urness is a graduate of the University of St. Thomas and William Mitchell College of Law.
Item 1A — Risk Factors
FORWARD-LOOKING STATEMENTS / RISK FACTORS
We make written and oral statements from time to time regarding our business and prospects, such as projections of future performance, statements of management’s plans and objectives, forecasts of market trends, and other matters that are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Statements containing the words or phrases “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimates,” “projects,” “believes,” “expects,” “anticipates,” “intends,” “target,” “goal,” “plans,” “objective,” “should” or similar expressions identify forward-looking statements, which may appear in documents, reports, filings with the Securities and Exchange Commission, including this Annual Report, news releases, written or oral presentations made by officers or other representatives made by us to analysts, shareholders, investors, news organizations and others and discussions with management and other representatives of us. For such statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.
Our future results, including results related to forward-looking statements, involve a number of risks and uncertainties. No assurance can be given that the results reflected in any forward-looking statements will be achieved. Any forward-looking statement made by or on behalf of us speaks only as of the date on which such statement is made. Our forward-looking statements are based on assumptions that are sometimes based upon estimates, data, communications and other information from suppliers, government agencies and other sources that may be subject to revision. Except as required by law, we do not undertake any obligation to update or keep current either (i) any forward-looking statement to reflect events or circumstances arising after the date of such statement, or (ii) the important factors that could cause our future results to differ materially from historical results or trends, results anticipated or planned by us, or which are reflected from time to time in any forward-looking statement which may be made by or on behalf of us.
In addition to other matters identified or described by us from time to time in filings with the SEC, there are several important factors that could cause our future results to differ materially from historical results or trends, results anticipated or planned by us, or results that are reflected from time to time in any forward-looking statement that may be made by or on behalf of us. Some of these important factors, but not necessarily all important factors, include the following:
Risks Relating To Our Business And Industry
We derive a substantial portion of our total net sales from a small group of customers. A reduction in sales to any of these customers could have a material adverse effect on our net sales and profitability.
For the fiscal year ended March 31, 2006, net sales to two customers, Best Buy and Wal-Mart/Sam’s Club accounted for approximately 18% and 12%, respectively, of our total net sales, and, in the aggregate, approximately 30% of our total net sales. For the fiscal year ended March 31, 2005, net sales to two customers, Best Buy and Wal-Mart/Sam’s Club accounted for approximately 19% and 20%, respectively, of our total net sales, and, in the aggregate, approximately 39% of our total net sales. For the fiscal year ended March 31, 2004, net sales to three customers, Best Buy, CompUSA and Sam’s Club, represented approximately 18%, 13% and 11%, respectively, of our total net sales, and, in the aggregate, approximately 42% of our total net sales. We believe that sales to a small group of customers will continue to represent a significant percentage of our total net sales. Substantially all of the products we distribute to these customers are supplied on a non-exclusive basis under arrangements that may be cancelled without cause and upon short notice, and our retail customers generally are not required to make minimum purchases. If we are unable to continue to sell our products to all or any of these customers or are unable to maintain our sales to these customers at current levels and cannot find other customers to replace these sales, there would be an adverse impact on our net sales and profitability. There can be no assurance that we will continue to recognize a significant amount of revenue from sales to any specific customer.
The loss of a significant vendor or manufacturer or a decline in the popularity of its products could negatively affect our product offerings and reduce our net sales and profitability.
A significant portion of our increase in net sales in recent years has been due to increased sales of PC software provided by software publishers such as Symantec Corporation, Roxio, Inc., Adobe Systems Inc., McAfee, Inc. and Dreamcatcher Interactive, Inc. During the fiscal years ended March 31, 2006, 2005 and 2004, each of these publishers accounted for more than $5.0 million in net sales. The largest of these is due to sales under our agreement with Symantec which accounted for approximately $86.9 million, $91.0 million and $51.0 million in net sales for the fiscal years ended March 31, 2006, 2005 and 2004, respectively. While we have agreements in place with each of these parties, such agreements generally are short-term agreements that may be cancelled without cause and upon short notice; they generally cover the right to distribute in the United States and Canada; they do not restrict the publishers from distributing their products through other distributors or directly to retailers; and they do not guarantee product availability to us for distribution. These agreements allow us to purchase the publishers’ products at a reduced wholesale price and to provide various distribution and fulfillment services in connection with the publishers’ products. If we were to lose our right to distribute products of any of the above PC software publishers or the popularity of such product were to decrease, our net sales and profitability would be adversely impacted.
Our future growth and success depends partly upon our ability to procure and renew popular product distribution agreements and to sell the underlying products. There can be no assurance that we will enter into new distribution agreements or that we will be able to sell products under existing distribution agreements. Further, our current distribution agreements may be terminated on short notice. The loss of a significant vendor could negatively affect our product offerings and, accordingly, our net sales. Similarly, a decrease in customer demand for such products could negatively affect our net sales.
The loss of our founder could affect the depth, quality and effectiveness of our management team. In addition, if we fail to attract and retain qualified personnel, the depth, quality and effectiveness of our management team and employees could be negatively affected.
Eric H. Paulson, our Chief Executive Officer and founder, has been with us since our inception in 1983. Mr. Paulson’s employment agreement currently extends through March 31, 2007, and the loss of or change in Mr. Paulson’s services, or the failure to execute a smooth transition plan could negatively affect the operation of the business.
Our ability to enhance and develop markets for our current products and to introduce new products to the marketplace also depends on our ability to attract and retain qualified management personnel. We compete for such personnel with other companies and organizations, many of which have substantially greater capital resources and name recognition than we do. If we are not successful in recruiting or retaining such personnel, it could have a material adverse effect on our business.
We may not be able to sustain the recent growth in our publishing segment.
Our publishing business has grown significantly over the past three fiscal years. Our discussions of changes in financial position and results of operations of this business may not be indicative of future performance, and this segment’s financial results may significantly vary in future quarters.
We could encounter difficulties in the operation of this segment that could negatively affect its financial condition and results of operation. Accordingly, there is no assurance that we will be able to continue to grow this segment of our business. Investors should not rely on the past performance of our publishing segment as an indicator of our future growth, and there can be no assurance that we will be able to successfully implement our publishing growth strategy.
Our business is seasonal and variable in nature and, as a result, the level of sales and payment terms during our peak season could adversely affect our results of operations and liquidity.
Traditionally, our third quarter (October 1-December 31) has accounted for our largest quarterly revenue figures and a substantial portion of our earnings. Our third quarter accounted for approximately 31.2%, 30.6% and 32.1% of our net sales for the fiscal years ended March 31, 2006, 2005 and 2004. As a distributor of products ultimately sold to consumers, our business is affected by the pattern of seasonality common to other suppliers of retailers, particularly during the holiday season. Because of this seasonality, if we or our customers experience a weak holiday season or if we provide extended payment terms for sales during the holiday season or determine to increase our inventory levels to meet anticipated retail customer demand, our financial results and liquidity or could be negatively affected. In addition, our borrowing levels and inventory levels can increase substantially during this time. For example, during the 2004 holiday season, we increased our inventory of certain PC software products to satisfy potential retail customer demand for such products, which temporarily caused our inventory and borrowing levels to be higher than usual. In addition to seasonality issues, other factors contribute to the variability of our revenues and cash flows in our business segments on a quarterly basis. These factors include:
| • | the popularity of the pre-recorded music, DVD and PC software titles released during the quarter; | ||
| • | product marketing and promotional activities; | ||
| • | the opening and closing of retail stores by our major customers; | ||
| • | the extension, termination or non-renewal of existing distribution agreements and licenses; and | ||
| • | general economic changes affecting the buying pattern of retailers, particularly those changes affecting consumer demand for home entertainment products and PC software. |
Pending litigation or regulatory inquiry may subject us to significant litigation costs, judgments or penalties and could divert management attention.
We are involved in a number of litigation matters, including shareholder class action suits and derivative suits, as well as an informal inquiry by the U.S. Securities and Exchange Commission. Irrespective of the validity of the assertions made in these suits or the positions asserted in these proceedings or any final resolution in these matters, we could incur substantial costs and management’s attention could be diverted, which could adversely affect our business, financial condition or operating results.
A substantial portion of FUNimation’s revenues typically derive from a small number of licensed properties and a small number of licensors and FUNimation’s content is highly concentrated in the anime genre.
FUNimation derives a substantial portion of its revenues from a small number of properties and such properties usually generate revenues only for a limited period of time. Additionally, FUNimation’s content is concentrated in the anime sector and its revenues are highly subject to the changing trends in the toy, game and entertainment businesses. In particular, one licensed property accounted for $9.7 million, or 27% of FUNimation’s net sales for the fiscal year ended March 31, 2006. FUNimation’s revenues may fluctuate significantly from year to year due to, among other reasons, the popularity of its licensed properties and the timing of entering into new licensing contracts.
During the fiscal year ended March 31, 2006, 61% of FUNimation’s revenues, were derived from sales of products under multiple licensing arrangements with three licensors. The loss of any of these licensing relationships could have a material negative effect on FUNimation’s revenues.
FUNimation’s revenues are substantially dependent on television exposure for its licensed properties.
The ability for certain anime and children’s entertainment content to gain television exposure is an important promotional vehicle for home video sales and licensing opportunities. To the extent that FUNimation’s content is not able to gain television exposure, sales of these products could be limited. Similarly, demand for properties broadcast on television generally is based on television ratings. In addition, FUNimation does not own the broadcast rights for some of its properties, so it depends on third parties to secure or renew broadcast rights for such content. A decline in television ratings or programming time of FUNimation’s licensed properties could adversely affect FUNimation’s revenues.
FUNimation’s revenues are dependent on consumer preferences and demand.
FUNimation’s business and operating results depend upon the appeal of its properties, product concepts and programming to consumers, including the popularity of anime in the United States market and trends in the toy, game and entertainment businesses. A decline in the popularity of its existing properties or the failure of new properties and product concepts to achieve and sustain market acceptance could result in reduced overall revenues, which could have a material adverse effect on FUNimation’s business, financial condition and results of operations. Consumer preferences with respect to entertainment are continuously changing and are difficult to predict and can vary from months to years and entertainment properties often have short life cycles. There can be no assurances that:
| • | any of FUNimation’s current properties, product concepts or programming will continue to be popular for any significant period of time; | ||
| • | any new properties, product concepts or programming FUNimation represents or produces will achieve an adequate degree of popularity; or | ||
| • | any property’s life cycle will be sufficient to permit FUNimation to profitably recover advance payments, guarantees, development, marketing, royalties and other costs. |
FUNimation’s failure to successfully anticipate, identify and react to consumer preferences could have a material adverse effect on FUNimation’s revenues, profitability and results of operations. In addition, changes in consumer preferences may cause its revenues and net income to vary significantly between comparable periods.
If we fail to meet our significant working capital requirements or if our working capital requirements increase substantially, our business and prospects could be adversely affected.
As a distributor and publisher, we purchase and license products directly from manufacturers and content developers for resale to retailers. As a result, we have significant working capital requirements, principally to acquire inventory, procure licenses and finance accounts receivable. Our working capital needs will increase as our inventory, licensing activities and accounts receivable increase in response to our growth. In addition, license advances, prepayments to enhance margins, investments, and inventory increases to meet customer requirements could increase our working capital needs. The failure to obtain additional financing or maintain working capital credit facilities on reasonable terms in the future could adversely affect our business. In addition, if the cost of financing is too expensive or not available, it could require a reduction in our distribution or publishing activities.
We rely upon bank borrowings to fund our general working capital needs and it may be necessary for us to secure additional financing in the future depending upon the growth of our business and the possible financing of additional acquisitions. If we were
unable to borrow under our credit facility or otherwise unable to secure sufficient financing on acceptable terms or at all, our future growth and profitability could be adversely affected.
Product returns or inventory obsolescence could reduce our sales and profitability or negatively impact our liquidity.
We maintain a significant investment in product inventory. Like other companies operating in our industry, product returns from our retail customers are significant when expressed as a percentage of revenues. Adverse financial or other developments with respect to a particular supplier or product could cause a significant decline in the value and marketability of our products, possibly making it difficult for us to return products to a supplier or recover our initial product acquisition costs. Under such circumstances, our sales and profitability, including our liquidity, could be adversely affected. We maintain a sales return reserve based on historical product line experience rates. There can be no assurance that our reserves will be adequate to cover potential returns.
We are subject to the risk that our inventory values may decline due to, among other things, changes in demand and that protective terms under our supplier agreements may not adequately cover the decline in values, which could result in lower gross margins or inventory write-downs.
The demand for products that we sell and distribute is subject to rapid technological change, new and enhanced product specification requirements, consumer preferences and evolving industry standards. These changes may cause our inventory to decline substantially in value or to become obsolete which may occur in a short period of time. We generally are entitled to receive a credit from certain suppliers for products returned to us based upon the terms and conditions with those suppliers, including maintaining a minimum level of inventory of their products and limitations on the amount of product that can be returned and/or restocking fees. If major suppliers decrease or eliminate the availability of price protection or inventory returnability to us, such a change in policy could lower our gross margins or cause us to record inventory write-downs. We are also exposed to inventory risk to the extent that supplier protections are not available on all products or quantities and are subject to time restrictions. In addition, suppliers may become insolvent and unable to fulfill their protection obligations to us. As a result, these policies do not protect us in all cases from declines in inventory value or product demand. We offer no assurance that price protection or inventory returnability terms may not change or be eliminated in the future, that unforeseen new product developments will not materially adversely affect our revenues or profitability or that we will successfully manage our existing and future inventories.
In our publishing business, prices could decline due to decreased demand and, therefore, there may be greater risk of declines in inventory value. To the extent that our publishing business has not properly reserved for inventory exposure or price reductions needed to sell remaining inventory, our profitability may suffer.
We have significant credit exposure and negative trends or other factors could cause us significant credit loss.
We provide credit to our customers for a significant portion of our net sales. During the holiday season, certain of our retail customers may request and be granted extended payment terms. Extended terms could require additional borrowings under our credit facilities. We are subject to the risk that our customers will not pay for the products they have purchased. This risk may increase if our customers experience decreases in demand for their products and services or become less financially stable due to adverse economic conditions or otherwise. If there is a substantial deterioration in the collectibility of our receivables, our earnings and cash flows could be adversely affected.
In addition, from time to time, we may make royalty advances, or loans to, or invest in, other businesses. These business or investment opportunities may not be successful, which could result in the loss of our invested capital.
We may not be able to adequately adjust our cost structure in a timely fashion in response to a decrease in net sales, which may cause our profitability to suffer.
A significant portion of selling, general and administrative expense is comprised of personnel, facilities and costs of invested capital. In the event of a significant downturn in net sales, we may not be able to exit facilities, reduce personnel, improve business processes, reduce inventory or make other significant changes to our cost structure without significant disruption to our operations or without significant termination and exit costs. Additionally, if management is not be able to implement such actions in a timely manner or at all to offset a shortfall in net sales and gross profit, our profitability would suffer.
Our distribution and publishing businesses operate in highly competitive industries and compete with large national firms. Further competition, among other things, could reduce our sales volume and margins.
The business of distributing home entertainment and multimedia products is highly competitive. Our competitors in the distribution business include other national and regional distributors as well as suppliers that sell directly to retailers. These competitors include the distribution affiliates of Time-Warner, Sony/BMG Music Entertainment, EMI, Ingram Micro and Tech Data Corporation. Our competitors in the publishing business include both independent national publishers as well as large international firms. These competitors include Ventura, Madacy, Direct Source, Platinum Image, Topics, Vivendi and Buena Vista. Certain of our competitors have substantially greater financial and other resources than we have. Our ability to compete effectively in the future depends upon a number of factors, including our ability to:
| • | obtain exclusive national distribution contracts and licenses with independent music labels and manufacturers; | ||
| • | obtain proprietary publishing rights with various rights holders and brand owners; | ||
| • | maintain our margins and volume; | ||
| • | expand our sales through a varied range of products and personalized services; | ||
| • | anticipate changes in the marketplace including technological developments and consumer interest in our proprietary products; and | ||
| • | maintain operating expenses at an appropriate level. |
Our failure to perform adequately one or more of these tasks may materially harm our business.
In addition, FUNimation’s business depends upon its ability to procure and renew agreements to license certain rights for attractive titles on favorable terms. Competition for attractive children’s anime and children’s entertainment content and television broadcasting slots is intense. FUNimation’s principal competitors in the anime sector are media companies such as AD Vision, 4Kids Entertainment, VIZ and Geneon and Japanese rights holders operating in the United States. FUNimation also competes with various toy companies, other licensing companies, numerous others acting as licensing representatives and large media companies such as Disney and Time Warner. Many of FUNimation’s competitors have substantially greater resources than FUNimation and own or license properties which are more commercially successful than FUNimation’s properties. There are low barriers to enter the licensing and brand management business and therefore there is potential for new competitors to enter the market.
Competition in the home entertainment and multimedia products industries is intense and is often based on price. Distributors generally experience low gross profit margins and operating margins. Consequently, our distribution profitability is highly dependent upon achieving effective cost and management controls and maintaining sales volumes. A material decrease in our gross profit margins or sales volumes would harm our financial results.
We depend on third party shipping and fulfillment companies for the delivery of our products.
We rely almost entirely on arrangements with third party shipping and fulfillment companies, principally UPS and Federal Express, for the delivery of our products. The termination of our arrangements with one or more of these third party shipping companies, or the failure or inability of one or more of these third party shipping companies to deliver products on a timely basis from suppliers to us, or products from us to our reseller customers or their end-user customers, could disrupt our business and harm our reputation and net sales. Furthermore, an increase in amounts charged by these shipping companies could negatively affect our gross margins and earnings.
We depend on a variety of systems for our operations, and a failure of these systems could disrupt our business and harm our reputation and net sales and negatively impact our results of operations.
We depend on a variety of systems for our operations. Certain of these systems are operated by third parties and their performance may be outside of our control. These systems support our operating functions, including inventory management, order processing, shipping, receiving and accounting. Any failures or significant downtime in our systems could prevent us from taking customer orders, printing product pick-lists, and/or shipping product. It could also prevent customers from accessing our price and product availability information.
From time to time we may acquire other businesses having information systems and records, which may be converted and integrated into our information systems. This can be a lengthy and expensive process that results in a material diversion of resources from other operations. In addition, because our information systems are comprised of a number of legacy, internally-developed applications, they can be harder to upgrade and may not be adaptable to commercially available software. As our needs for technology evolve, we may experience difficulty or significant cost in upgrading or significantly replacing our systems.
We also rely on the Internet for a portion of our orders and information exchanges with our customers. The Internet and individual websites can experience disruptions and slowdowns. In addition, some websites have experienced security breakdowns. Our website could experience material breakdowns, disruptions or breaches in security. If we were to experience a security breakdown, disruption or breach that compromised sensitive information, this could harm our relationship with our customers or suppliers. Disruption of our website or the Internet in general could impair our order processing or more generally prevent our customers and suppliers from accessing information. This could cause us to lose business.
We believe that customer information systems and product ordering and delivery systems, including Internet-based systems, are becoming increasingly important in the distribution of our products and services. Although we seek to enhance our customer information systems by adding new features, we offer no assurance that competitors will not develop superior customer information systems or that we will be able to meet evolving market requirements by upgrading our current systems at a reasonable cost, or at all. Our inability to develop competitive customer information systems or upgrade our current systems could cause our business and market share to suffer.
Technology developments, particularly in the electronic downloading arena, may adversely affect our net sales, margins and results of operations.
Home entertainment products have traditionally been marketed and delivered on a physical delivery basis. If, in the future, these products are increasingly marketed and delivered through technology transfers, such as electronic downloading through the Internet or similar delivery methods, then our retail and wholesale distribution business could be negatively impacted. As electronic downloading grows through Internet retailers, competition between suppliers to electronic retailers in traditional ways will intensify and likely negatively impact our net sales and margins. Furthermore, we may be required to spend significant capital to enter or participate in this delivery channel. If we are unable to develop necessary vendor and customer relationships to facilitate electronic downloading or if the terms of these arrangements differ from those related to our physical product sales, our business may be materially harmed.
We may not be successful in implementing our acquisition strategy, and future acquisitions could result in disruptions to our business by, among other things, distracting management time and diverting financial resources. Further, if we are unsuccessful in integrating acquired companies into our business, it could materially and adversely affect our financial condition and operating results.
One of our growth strategies is the acquisition of complementary businesses. We may not be able to identify suitable acquisition candidates or, if we do, we may not be able to make such acquisitions on commercially acceptable terms or at all. If we make acquisitions, a significant amount of management’s time and financial resources may be required to complete the acquisition and integrate the acquired business into our existing operations. Even with this investment of management time and financial resources, an acquisition may not produce the revenue, earnings or business synergies anticipated. Acquisitions involve numerous other risks, including assumption of unanticipated operating problems or legal liabilities, problems integrating the purchased operations, technologies or products, diversion of management’s attention from our core businesses, adverse effects on existing business relationships with suppliers and customers, incorrect estimates made in the accounting for acquisitions and amortization of acquired intangible assets that would reduce future reported earnings (goodwill impairments), ensuring acquired companies’ compliance with the requirements of the Sarbanes-Oxley Act of 2002 and potential loss of customers or key employees of acquired businesses. We cannot assure you that if we make any future acquisitions, investments, strategic alliances or joint ventures they will be completed in a timely manner or achieve anticipated synergies, that they will be structured or financed in a way that will enhance our business or creditworthiness or that they will meet our strategic objectives or otherwise be successful. In addition, we may not be able to secure the financing necessary to consummate future acquisitions, and future acquisitions and investments could involve the issuance of additional equity securities or the incurrence of additional debt, which could harm our financial condition or creditworthiness.
Increased counterfeiting or piracy may negatively affect the demand for our home entertainment products.
The recorded music and motion picture industries have been adversely affected by counterfeiting of audiocassettes, CDs and DVDs, piracy and parallel imports, and also by websites and technologies that allow consumers to illegally download and access music and video. Increased proliferation of these alternative access methods to these products could impair our ability to generate net sales and could cause our business to suffer.
We may not be able to successfully protect our intellectual property rights.
We rely on a combination of copyright, trademark and other proprietary rights laws to protect the intellectual property we license. Third parties may try to challenge the ownership by us or our licensors of such intellectual property. In addition, our business is subject to the risk of third parties infringing on our intellectual property rights or those of our licensors and producing counterfeit products. We may need to resort to litigation in the future to protect our intellectual property rights or those of our licensors, which could result in substantial costs and diversion of resources and could have a material adverse effect on our business and competitive position.
Interruption of our business or catastrophic loss at any of our facilities could lead to a curtailment or shutdown of our business.
We receive, manage and distribute our inventory from a centralized warehouse and distribution facility that is located adjacent to our corporate headquarters. An interruption in the operation of or in the service capabilities at this facility or our separate returns processing center as a result of equipment failure or other reasons could result in our inability to distribute products, which would reduce our net sales and earnings for the affected period. In the event of a stoppage at such facilities, even if only temporary, or if we experience delays as a result of events that are beyond our control, delivery times to our customers and our relationship with such customers could be severely affected. Any significant delay in deliveries to our customers could lead to increased returns or
cancellations and cause us to lose future sales. Our facilities are also subject to the risk of catastrophic loss due to unanticipated events such as fires, explosions, violent weather conditions or other natural disasters. We may experience a shutdown of our facilities or periods of reduced production as a result of equipment failure, delays in deliveries or catastrophic loss, which could have a material adverse effect on our business, results of operations or financial condition.
Future terrorist or military actions could result in disruption to our operations or loss of assets, in certain markets or globally.
Future terrorist or military actions, in the U.S. or abroad, could result in destruction or seizure of assets or suspension or disruption of our operations. Additionally, such actions could affect the operations of our suppliers or customers, resulting in loss of access to products, potential losses on supplier programs, loss of business, higher losses on receivables or inventory, or other disruptions in our business, which could negatively affect our operating results. We do not carry insurance covering such terrorist or military actions, and even if we were to seek such coverage and such coverage were available, the cost likely would not be commercially reasonable.
Legislative actions, higher director and officer insurance costs and potential new accounting pronouncements are likely to cause our general and administrative expenses to increase and impact our future financial condition and results of operations.
In order to comply with the Sarbanes-Oxley Act of 2002, as well as changes to the NASDAQ listing standards and rules adopted by the Securities and Exchange Commission, we have been required to strengthen our internal controls, hire additional personnel and retain additional legal, accounting and advisory services, all of which have caused and could continue to cause our general and administrative costs to increase. In addition, insurers have increased and could continue to increase premiums for our directors’ and officers’ insurance policies.
Our financial statements are prepared in accordance with U.S. generally accepted accounting principles. These principles are subject to interpretation by various governing bodies, including the FASB, the Public Company Accounting Oversight Board (the “PCAOB”), and the SEC, who create and interpret appropriate accounting standards. A change from current accounting standards could have a significant adverse effect on our results of operations. For example, the FASB’s new guidance that addresses the accounting for share-based payments, FAS No. 123R. will become effective for the Company beginning in its first quarter of fiscal 2007. FAS 123R as amended requires compensation cost relating to all share-based payments to employees to be recognized in the financial statements based on their fair values. We currently expect the amount of share-based compensation expense related to the options outstanding and un-vested at March 31, 2006 included in operating expenses to be approximately $176,000 in fiscal 2007.
Any material weakness or significant deficiency in our internal controls may adversely affect our ability to report our financial results on a timely and accurate basis.
Section 404 of the Sarbanes-Oxley Act of 2002 requires that companies evaluate and report on their internal control structure and procedures over financial reporting. In addition, our independent auditors must report on management’s evaluation as well as evaluate our internal control structure and procedures. If any material weaknesses are identified in the future which we are unable to successfully address, our ability to report our financial results on a timely and accurate basis may be adversely affected.
Risks Relating to Indebtedness
The level of our indebtedness could adversely affect our financial condition.
We have significant debt service obligations. As of March 31, 2006, our total indebtedness under our credit agreement is $80.1 million. We also have the ability to borrow an additional $25.0 million under this credit agreement.
The level of our indebtedness could have important consequences. For example, it could:
| • | make it more difficult for us to satisfy our obligations with respect to other indebtedness; | ||
| • | increase our vulnerability to adverse economic and industry conditions; | ||
| • | require us to dedicate a substantial portion of our cash flow from operations to the payment of our indebtedness, thereby reducing the availability of cash to fund working capital and capital expenditures and for other general corporate purposes; | ||
| • | restrict us from making strategic acquisitions, acquiring new content or exploring other business opportunities; |
| • | limit our ability to obtain financing for working capital, capital expenditures, general corporate purposes or acquisitions; | ||
| • | place us at a disadvantage compared to our competitors that have less indebtedness; and | ||
| • | limit our flexibility in planning for, or reacting to, changes in our business and industry. |
Our outstanding indebtedness bears interest at variable rates. Any increase in interest rates will reduce funds available to us for our operations and future business opportunities and will adversely affect our leveraged capital structure.
Our debt service requirements will be impacted by changing interest rates. Of our $80.1 million in debt outstanding at March 31, 2006, $27.1 million is subject to variable interest rates, as the remaining portion is covered by an interest rate swap. A 100-basis point change in LIBOR would cause our projected annual interest expense to change by approximately $271,000. The fluctuation in our debt service requirements, in addition to interest rate changes, may be impacted by future borrowings under our credit facility or other alternative financing arrangements.
We may be unable to generate sufficient cash flow to service our debt obligations.
Our ability to make payments on and to refinance our indebtedness and to fund our operations, working capital and capital expenditures, depends on our ability to generate cash in the future, which is subject to general economic, industry, financial, competitive, operating, legislative, regulatory and other factors that are beyond our control. Additionally, if the interest rate swap is removed or principal payments are made early, additional expense may be incurred.
We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available to us under our credit agreement in an amount sufficient to enable us to pay amounts due on our indebtedness or to fund our other liquidity needs.
We may need to refinance all or a portion of our indebtedness on or before maturity. Our ability to refinance our indebtedness or obtain additional financing will depend on, among other things:
| • | our financial condition at the time; | ||
| • | restrictions in our credit agreement or other outstanding indebtedness; and | ||
| • | other factors, including the condition of the financial markets or the distribution and publishing markets. |
As a result, we may not be able to refinance any of our indebtedness on commercially reasonable terms, or at all. If we do not generate sufficient cash flow from operations, and additional borrowings or refinancings or proceeds of asset sales are not available to us, we may not have sufficient cash to enable us to meet all of our obligations.
We may be able to incur additional indebtedness, which could further exacerbate the risks associated with our current indebtedness level.
We and our subsidiaries may be able to incur substantial additional indebtedness in the future. Although our credit facility contains restrictions on the incurrence of additional indebtedness, debt incurred in compliance with these restrictions could be substantial. Our revolving working capital credit facility provided pursuant to a credit agreement, permits total borrowings of up to an additional $25.0 million. In addition, our credit agreement will not prevent us from incurring certain other obligations. If we and our subsidiaries incur additional indebtedness or other obligations, the related risks that we and they face could be magnified.
Our credit agreement contains significant restrictions that limit our operating and financial flexibility.
Our credit agreement requires us to maintain specified financial ratios and we may be unable to meet such ratios. All of these restrictions may limit our ability to execute our business strategy. Moreover, if operating results fall below current levels, we may be unable to comply with these covenants. If that occurs, our lenders could accelerate our indebtedness, in which case we may not be able to repay all of our indebtedness.
Risks Relating to Our Common Stock
Our common stock price has been volatile. Fluctuations in our stock price could impair our ability to raise capital and make an investment in our securities undesirable.
The market price of our common stock has fluctuated significantly. We believe factors such as the market’s acceptance of our products and the performance of our business relative to market expectations, as well as general volatility in the securities markets, could cause the market price of our common stock to fluctuate substantially. In addition, the stock markets have experienced price and volume fluctuations, resulting in changes in the market prices of the stock of many companies, which may not have been directly related to the operating performance of those companies. Fluctuations in our stock price could impair our ability to raise capital and make an investment in our securities undesirable. During the period from April 1, 2005 to March 31, 2006, the last reported price of our common stock as quoted on the NASDAQ National Market ranged from a low of $3.45 to a high of $9.21.
The exercise of outstanding warrants and options may adversely affect our stock price.
Our stock option plans authorize the issuance of options to purchase 7.7 million shares of our common stock. As of March 31, 2006, options and warrants to purchase 4,937,101 shares of our common stock were outstanding. Approximately 2,937,300 options and warrants were exercisable as of March 31, 2006. Warrants totaling 1,596,001 were issued in connection with the private placement completed in March 2006. Our outstanding options and warrants are likely to be exercised at a time when the market price for our common stock is higher than the exercise prices of the options and warrants. If holders of these outstanding options and warrants sell the common stock received upon exercise, it may have a negative effect on the market price of our common stock.
Our anti-takeover provisions, our ability to issue preferred stock and our staggered board may discourage takeover attempts that could be beneficial for our shareholders.
We are subject to Sections 302A.671 and 302A.673 of the Minnesota Business Corporation Act, which may have the effect of limiting third parties from acquiring significant amounts of our common stock without our approval. These laws, among others, may have the effect of delaying, deferring or preventing a third party from acquiring us or may serve as a barrier to shareholders seeking to amend our articles of incorporation or bylaws. Our articles of incorporation also permit us to issue preferred stock, which could allow us to delay or block a third party from acquiring us. The holders of preferred stock could also have voting and conversion rights that could adversely affect the voting power of the holders of the common stock. Finally, our articles of incorporation and bylaws divide our board of directors into three classes that serve staggered, three-year terms. Each of these factors could make it difficult for a third party to effect a change in control of us. As a result, our shareholders may lose opportunities to dispose of their shares at the higher prices typically available in takeover attempts or that may be available under a merger proposal.
In addition, these measures may have the effect of permitting our current directors to retain their positions and place them in a better position to resist changes that our shareholders may wish to make if they are dissatisfied with the conduct of our business.
We currently do not intend to pay dividends on our common stock and, consequently, your only opportunity to achieve a return on your investment is if the price of our common stock appreciates.
We currently do not plan to declare dividends on shares of our common stock in the foreseeable future. Further, the payment of dividends by us is restricted by our credit facility. Consequently, your only opportunity to achieve a return on your investment is if the price of our common stock appreciates and you sell your shares at a profit.
Our directors may not be held personally liable for certain actions, which could discourage shareholder suits against them.
Minnesota law and our articles of incorporation and bylaws provide that our directors shall not be personally liable to us or our shareholders for monetary damages for breach of fiduciary duty as a director, with certain exceptions. These provisions may discourage shareholders from bringing suit against a director for breach of fiduciary duty and may reduce the likelihood of derivative litigation brought by shareholders on behalf of us against a director. In addition, our bylaws provide for mandatory indemnification of directors and officers to the fullest extent permitted by Minnesota law.
Other Risks
We operate a large business in a continually changing environment that involves numerous risks and uncertainties. It is not reasonable for us to itemize all of the factors that could affect us and/or the products and services distribution industry or the publishing industry as a whole. Future events that may not have been anticipated or discussed here could adversely affect our business, financial condition, results of operations or cash flows.
Thus, the foregoing is not a complete description of all risks relevant to our future performance, and the foregoing risk factors should be read and understood together with and in the context of similar discussions which may be contained in the documents that we file with the SEC in the future. We undertake no obligation to release publicly any revision to the foregoing or any update to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.
Item 1B. Unresolved Staff Comments
Not applicable.
