Varsity Group, Inc (VSTY) - Description of business
HAS EXPERIENCED SIGNIFICANT GROWTH OVER THE LAST THREE FISCAL YEARS. CONTINUED GROWTH AT THE LEVELS WE HAVE EXPERIENCED OUR LAST THREE FISCAL YEARS WILL PLACE A STRAIN ON OUR MANAGEMENT, OPERATIONAL AND FINANCIAL RESOURCES. Our total revenues and total employees have grown over 200% over our last three years. We are rapidly expanding our operations and will continue to expand further to pursue growth of our core eduPartners business and expand into new markets, as evidenced by the acquisition of Campus Outfitters in May 2005. Such growth increases the complexity of our business and places a significant strain on our management, operations, and financial resources, and there can be no assurance that we will be able to manage it effectively. Our current and planned personnel, systems, procedures, and controls may not be adequate to support and effectively manage our future operations. We may not be able to hire, train, retain, motivate, and manage required personnel, which may limit our growth. If any of this were to occur, it could damage our reputation, limit our growth, adversely affect our operating results and harm our business. WE FACE SIGNIFICANT INVENTORY RISK WITH OUR TEXTBOOKS. Our textbook inventory balance as of December 31, 2005 consisted mainly of: New textbook inventory held at B&T, our fulfillment partner, acquired by B&T in support of our eduPartners program for which they generally do not enjoy standard return privileges with publishers and new textbooks held at Campus Outfitters retail locations and at other locations; and Used textbooks held at B&T, Campus Outfitters retail locations, or other locations. Under our agreement with B&T in which B&T provides our order fulfillment and drop shipment services, B&T assumes ownership of all new textbooks until shipment and does not assume ownership of the used products it processes for us. Approximately 90% of new textbook unsold inventory at B&T is returned for credit with our publishers, which substantially reduces our risk of inventory obsolescence, however, we take title to the remaining unsold inventory and write down this balance for estimated excess and obsolete or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions on a quarterly basis. Should textbook return privileges extended to B&T or us by publishers materially change, we may face increased inventory risk and higher working capital requirements which could adversely affect our operating results. To the extent that we continue to procure used textbooks and maintain textbook inventory at our Campus Outfitter retail operations, we will face increased inventory risk, which may adversely affect our operation results. LOSS OF ANY OF OUR KEY MANAGEMENT PERSONNEL OR THE INABILITY OF OUR KEY MANAGEMENT PERSONNEL TO WORK TOGETHER EFFECTIVELY OR SUCCESSFULLY MANAGE OUR GROWTH COULD NEGATIVELY AFFECT OUR BUSINESS. Our future success depends to a significant extent on the continued service and coordination of our management team, particularly Eric J. Kuhn, our co-founder and Chairman of the Board, Mark F. Thimmig, our President and Chief Executive Officer as of February 15, 2006, and Jack M Benson, our Chief Financial Officer. We have entered into agreements with Mr. Kuhn, Mr. Thimmig and Mr. Benson that provide, among other things, that they are compensated in the event they are terminated without cause. The loss or departure of any of our executive officers or key employees could harm our ability to implement our business plan. We do not maintain key person insurance on any member of our management team. IF WE ARE UNABLE TO ADAPT AS INTERNET TECHNOLOGIES AND CUSTOMER DEMANDS CONTINUE TO EVOLVE, OUR SERVICES AND PRODUCTS COULD BECOME LESS DESIRABLE. The satisfactory performance, reliability and availability of our website, transaction-processing systems and network infrastructure are critical to our reputation and our ability to attract and retain customers and maintain adequate customer service levels. An unanticipated dramatic increase in the volume of traffic on our website or the number of orders placed by our customers may force us to expand and upgrade our technology, transaction-processing systems and network infrastructure. There can be no assurance that we will be able to accurately project the rate or timing of increases, if any, in the use of our website or timely expand and upgrade our systems and infrastructure to accommodate such increases. To be successful, we must adapt to our rapidly changing market by continually enhancing the technologies used in our Internet products and services and introducing new technology to address the changing needs of our business and customers. If we are unable, for technical, legal, financial or other reasons, to adapt in a timely manner in response to changing market conditions or business and customer requirements, our business could be harmed. We are currently upgrading our information systems, which includes substantially all aspects of transaction processing, including order management, cash and credit card processing, purchasing, inventory management and shipping in order to accommodate the Campus Outfitters acquisition, the continued growth of our textbook program, and to comply with the numerous reporting and control requirements imposed by the Sarbanes Oxley Act, including Section 404. Our success, in particular our ability to successfully receive and fulfill orders and provide high-quality customer service, largely depends on the efficient and uninterrupted operation of our computer and communications hardware systems. We launched the first phase of the upgraded new system in our second quarter of fiscal 2004, however, the systems upgrades were complex. This complexity can make it difficult to detect errors or failure in our website prior to implementation. We may not immediately discover errors in our new system until the volume of orders placed by our customers significantly increases from the levels we experienced in our last fall back to school season. As a result, the upgraded website may not achieve the expected benefits. Unanticipated problems with our website may result in customer dissatisfaction, a loss of, or delays in, the market acceptance of our website, and lost revenue and collection difficulties during the period required to correct these errors. Failure to correct these problems may harm our reputation, our brand and our business. WE DEPEND ON A THIRD-PARTY SERVICE PROVIDER FOR OUR INFORMATION TECHNOLOGY INFRASTRUCTURE. IF OUR THIRD-PARTY SERVICE PROVIDER EXPERIENCES ANY SYSTEM FAILURE OR INADEQUACY, OUR OPERATIONS COULD BE JEOPARDIZED. Our operations are dependent on our ability to maintain our computer and communications software and equipment in effective working order and to protect our systems against damage from fire, natural disaster, power loss, communications failure or similar events. In addition, the growth of our customer base may strain or exceed the capacity of our computer and communications systems and lead to degradations in performance or systems failure. Our success, in particular our ability to successfully receive and fulfill orders and provide high-quality customer service, largely depends on the efficient and uninterrupted operation of our computer and communications hardware systems. We use an internally developed system for our website, search engine and substantially all aspects of transaction processing, including order management, cash and credit card processing, purchasing, inventory management and shipping. Substantially all of our computer and communications hardware and software systems associated with the operation of our website are located at a single facility in Sterling, Virginia. That facility is owned, maintained and serviced by Qwest Communications. Although we own and maintain our hardware and software systems, including the software which is central to the sales, ordering and shipping processes, we rely on Qwest to ensure our computer and communications hardware and software operate efficiently and continuously. We do not presently have fully redundant systems or a formal disaster recovery plan and do not carry sufficient business interruption insurance to compensate for losses that may occur. Communications circuits, including access to and from the Internet are currently supplied by Qwest Communications. A disruption in this Internet service could cause a disruption in our ability to service our clients. Despite our implementation of network security measures, our servers are vulnerable to computer viruses, physical or electronic break-ins, fire, flood, power loss, telecommunications failure, break-ins, earthquake and similar disruptions, which could lead to interruptions, delays, loss of data or the inability to accept and fulfill customer orders. Any damage, failure or delay that causes interruptions in our system operations could have a material adverse effect on our business. In addition to our offsite software and hardware related to our website, at our headquarters we maintain a local area network, or LAN, which we use for our financial reporting systems, customer service operations, monitoring of our customer orders, e-mails and other internal processes. Any loss of service or other failure of this LAN, regardless of the availability of our website, would significantly impair our ability to service our customers and monitor and fulfill customer orders, which could have a material adverse effect on our business. The failure of either our website or our LAN or any other systems interruptions that results in unavailability of our website or reduced order fulfillment performance, especially during the peak Fall sales period of July/August/September, could result in negative publicity or could reduce the volume of goods sold and attractiveness of our website and would seriously impair our ability to service our customers orders, all of which could negatively affect our revenues. Because our servers are located at a third-partys facility and because some of the reasons for a systems interruption may be outside of our control, we also may not be able to exercise sufficient control to remedy the problem quickly or at all. Regardless of whether we or a third-party controls or creates system failure, the occurrence of system failure could adversely affect our reputation, seriously harm our business and cause us to lose a significant and disproportionate amount of revenues. CONCERNS ABOUT SECURITY ON THE INTERNET MAY REDUCE THE USE OF OUR WEBSITE AND IMPEDE OUR GROWTH. A significant barrier to confidential communications over the Internet has been the need for security. We rely on SSL encryption technology designed to prevent the misappropriation of customer credit card data during the transaction process. Under current credit card practices, a merchant is liable for fraudulent credit card transactions where, as is the case with the transactions we process, that merchant does not obtain a cardholders signature. A failure to adequately control fraudulent credit card transactions could reduce our collections and harm our business. Internet usage could decline if any well-publicized compromise of security occurred. Our site could be particularly affected by any such breach because our online commerce model requires the entry of confidential customer ordering, purchasing and delivery data over the Internet, and we maintain a database of this historical customer information. Until more comprehensive security technologies are developed, the security and privacy concerns of existing and potential customers may inhibit the growth of the Internet as a medium for commerce. We cannot be certain that advances in computer capabilities, new discoveries in the field of cryptography or other developments will not result in the compromise or breach of the algorithms we use to protect content and transactions on our website or proprietary information in our databases. Anyone who is able to circumvent our security measures could misappropriate proprietary, confidential customer or company information or cause interruptions in our operations. We may incur significant costs to protect against the threat of such security breaches or to alleviate problems caused by these breaches. WE MAY BECOME SUBJECT TO BURDENSOME GOVERNMENT REGULATIONS AND LEGAL UNCERTAINTIES AFFECTING THE INTERNET THAT COULD ADVERSELY AFFECT OUR BUSINESS. To date, governmental regulations have not materially restricted use of the Internet in our markets. However, the legal and regulatory environment that pertains to the Internet is uncertain and may change. Uncertainty and new regulations could increase our costs of doing business and prevent us from delivering our products and services over the Internet. The growth of the Internet may also be significantly slowed. This could delay growth in demand for our online services and limit the growth of our revenues. In addition to new laws and regulations being adopted, existing laws may be applied to the Internet. New and existing laws may cover issues, which include: sales and other taxes; user privacy; pricing controls; characteristics and quality of products and services; consumer protection; libel and defamation; copyright, trademark and patent infringement; and other claims based on the nature and content of Internet materials. THE SARBANES OXLEY ACT OF 2002 IMPOSES ADDITIONAL OBLIGATIONS ON US, INCLUDING THE REQUIREMENT THAT WE DOCUMENT AND EVALUATE OUR INTERNAL CONTROLS. THIS EXERCISE HAS NO PRECEDENT AVAILABLE BY WHICH TO MEASURE THE ADEQUACY OF OUR COMPLIANCE AND MAY RESULT IN NON- COMPLAINCE WHICH MAY ADVERSLY AFFECT OUR STOCK PRICE. EFFORTS TO COMPLY WILL RESULT IN ADDITIONAL OPERATING EXPENSES, WHICH MAY MATERIALLY AFFECT OUR FINANCIAL RESULTS. The Sarbanes-Oxley Act of 2002 and newly proposed or enacted rules and regulations of the SEC and NASDAQ impose new duties on us and our executives, directors, attorneys and independent accountants. In order to comply with the Sarbanes-Oxley Act and such new rules and regulations, we are evaluating our internal controls systems to allow management to report on, and our independent registered public accounting firm to attest to, our internal controls over financial reporting. It is uncertain as to which fiscal year we will need to comply with Section 404 of the Sarbanes-Oxley Act, although it is possible that it could be applicable to us for our December 31, 2006 Form 10-K. We expect that our efforts to comply with these new regulations will result in significant increases in general and administrative expenses in fiscal 2006 as we may be required to hire additional personnel and use additional outside legal, accounting and advisory services. Additionally, we expect that our efforts to prepare to comply with these new regulations will also result in a diversion of management time and attention from operating activities to compliance activities. Any of these developments could materially increase our operating expenses or affect our operating performance, which would adversely affect financial results. While we anticipate being able to fully implement the requirements relating to the Sarbanes-Oxley Act in a timely fashion, we cannot be certain as to the outcome of our testing and resulting remediation actions or the impact of the same on our operations since there is no precedent available by which to measure compliance adequacy. If we are not able to implement the requirements of the Sarbanes-Oxley Act in a timely manner or with adequate compliance, we may be subject to sanctions or investigation by regulatory authorities, such as the SEC or NASDAQ, and our reputation may be harmed. Any such action could adversely affect our financial results and may adversely affect out stock price. Moreover, because these laws, regulations and standards are subject to varying interpretations, their application in practice may evolve over time as new guidance becomes available. This evolution may result in continuing uncertainty regarding compliance matters and additional costs necessitated by ongoing revisions to our disclosure and governance practices. NEW ACCOUNTING PRONOUNCEMENTS MAY NEGATIVELY IMPACT OUR STOCK PRICE. In December 2004, the Financial Accounting Standards Board, issued Statement of Financial Accounting Standards, or SFAS, No. 123R, Share-Based Payment. This statement, which is effective in our first quarter of 2006, changes how we account for share-based compensation and may negatively impact our stock price. The impact of adoption of SFAS No. 123R is difficult to predict at this time because it will depend on levels of share-based payments granted in the future. However, we believe if we had adopted SFAS No. 123R in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the notes to our consolidated financial statements. SFAS No. 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow. This requirement will reduce our net operating cash flows and increase our net financing cash flows in periods after adoption. OUR ACQUISITION OF CAMPUS OUTFITTERS MAY ADVERSELY AFFECT OUR COMBINED FINANCIAL RESULTS IN FUTURE YEARS. On May 26, 2005, we completed our first acquisition, acquiring substantially all of the assets of Campus Outfitters, a leading retailer of private elementary, middle and high school uniforms. As a result, we incurred acquisition and integration costs which contributed to a decrease in income before taxes. Although we expect the acquisition to be accretive to our earnings in fiscal 2006 and beyond, we may experience additional unforeseen integration expenditures or we may not realize expected synergies between our businesses. If this happens, our financial results may be adversely affected. WE MAY ENCOUNTER PROBLEMS EFFECTIVELY INTEGRATING CAMPUS OUTFITTERS. Acquisitions involve the integration of companies that have previously operated independently. In connection with the Campus Outfitters acquisition, there can be no assurance that we will: effectively integrate employees, operations, products and systems; realize the expected benefits of the transaction; retain key employees; realize all expected synergies; avoid unanticipated operational difficulties or expenditures or both; and effectively operate our existing textbook business, given the significant diversion of resources and management attention required to successfully integrate Campus Outfitters. In addition to the risks described above the ultimate success of our acquisition of Campus Outfitters is dependent on factors which include the following: our ability to retain and motivate Campus Outfitter key employees; our ability to fulfill our strategic plan for the acquisition of Campus Outfitters; and our ability, together with Campus Outfitters, to cross-sell our products between our respective client bases. IF WE ACQUIRE ANY ADDITIONAL COMPANIES IN THE FUTURE, THEY COULD PROVE DIFFICULT TO INTEGRATE, DISRUPT OUR CORE BUSINESS, DILUTE SHAREHOLDER VALUE AND ADVERSELY AFFECT OUR OPERATING RESULTS. We evaluate and enter into negotiations pertaining to possible acquisitions, strategic investments in businesses and joint ventures in the ordinary course of our business. New acquisitions or investments may be disruptive to our organization. In connection with any acquisitions or investments, there is no assurance that we will: effectively integrate operations, technologies, services and personnel; avoid a diversion of financial and managerial resources from existing operations; avoid assumption of unknown liabilities; avoid unanticipated operational difficulties or expenditures or both; retain key employees; generate sufficient revenue to offset acquisition or investment costs; and realize the expected benefits of the transaction. In addition, any future acquisition or investment may result in a dilution to existing shareholders to the extent we issue shares of our common stock as consideration or reduced liquidity and capital resources to the extent we use cash as consideration. OUR CAMPUS OUTFITTER BUSINESS DEPENDS IN PART ON THE AVAILABILITY OF SUITABLE LEASE SPACE TO SELL ITS SCHOOL UNIFORMS. Through our Campus Outfitters brand, we sell school uniforms to the private K-12 school marketplace at retail locations in Indiana, Maryland, Michigan, North Carolina, New York, Ohio, Texas and Virginia. Part of our future growth is dependent on our ability to continue to operate these stores in desirable locations with lease costs that allow us to earn a reasonable return. One retail location is currently leased month-to-month and the other retail locations have leases that are scheduled to expire between January 2007 and May 2015. There can be no assurance that we will be able to renew our current leases as they expire, or that new leases will be available on terms acceptable to us. Failure to renew expiring leases may harm our reputation, our brand and our business. IF WE DO NOT SUCCESSFULLY OPERATE OUR CAMPUS OUTFITTER RETAIL LOCATIONS, OUR BUSINESS COULD BE HARMED. If we do not successfully operate our Campus Outfitter retail locations, our ability to meet customer demand could be significantly limited. Because our business model has not depended on sales from retail locations in the past, we may not manage our retail facilities in an optimal way, which may result in an excess or insufficient amount of inventory at our retail locations. A failure to optimize inventory in our retail locations will increase our shipping costs, by requiring us to make additional shipments to or from retail locations or vendors. We may be unable to adequately staff our retail locations. As we expand our retail customer base, our fulfillment network may become increasingly complex and operating it will become more challenging. There can be no assurance that we will be able to operate our fulfillment network effectively. AS INTERNET TECHNOLOGY AND REGULATION ADVANCES, WE MAY NOT BE ABLE TO PROTECT OUR DOMAIN NAMES. We currently hold various Internet domain names relating to our brands, including the VarsityBooks.com, VarsityGroup.com, Varsity-Group.com and CampusOutfitters.com domain names. Governmental agencies and their designees generally regulate the acquisition and maintenance of domain names. The regulation of domain names in the generic category of domain names (i.e., .com, .net and .org) is now controlled by a non-profit corporation, which may create additional top-level domains. Requirements for holding domain names have also been affected. As a result, there can be no assurance that we will be able to acquire or maintain relevant domain names. Furthermore, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights. Any such inability could harm our business. SOME STATES MAY IMPOSE A NEW SALES TAX ON OUR BUSINESS. A 1992 Supreme Court decision held that the Commerce Clause of the United States Constitution limits a states ability to impose a sales or use tax collection responsibility on an out-of-state vendor unless such vendor maintains a physical presence, i.e., substantial nexus, in the taxing state. Based on this Supreme Court decision, we have determined that we do not have a substantial nexus in some jurisdictions where our products are received by customers, and, therefore, do not collect or remit sales or use tax in such jurisdictions. Because the scope of the 1992 Supreme Court decision is unclear, states may challenge our determination of substantial nexus. If successful, such challenges could result in significant liabilities for sales and use taxes with a material and adverse effect on our business. We currently collect and remit sales or use tax on all shipments to eighteen states. The 1992 Supreme Court decision also established that Congress has the power to enact legislation that would permit states to require collection of sales and use taxes by mail-order companies. Congress has from time to time considered proposals for such legislation. We anticipate that any legislative change, if adopted, would be applied on a prospective basis. While there is no case law on the issue, we believe that this analysis could also apply to our online business. Recently, several states and local jurisdictions have expressed an interest in taxing e-commerce companies who do not have any contacts with their jurisdictions other than selling products online to customers in such jurisdictions. OUR EXECUTIVE OFFICERS, DIRECTORS AND EXISTING STOCKHOLDERS, WHOSE INTERESTS MAY DIFFER FROM OTHER STOCKHOLDERS, HAVE THE ABILITY TO EXERCISE SIGNIFICANT CONTROL OVER US. As of December 31, 2005, our executive officers, directors and entities affiliated with them, in the aggregate, owned approximately 21% of our outstanding common stock. These stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors, the approval of significant corporate transactions and the power to prevent or cause a change of control. The interests of these stockholders may differ from the interests of our other stockholders. IF WE ARE UNABLE TO MAINTAIN OUR NASDAQ NATIONAL MARKET LISTING, OUR COMMON STOCK MAY BE SUBJECT TO DELISTING FROM THE NATIONAL MARKET AND YOUR ABILITY TO TRADE SHARES OF OUR COMMON STOCK COULD SUFFER. In September 2004, our common stock was approved for relisting on the NASDAQ National Market and began trading on the NASDAQ National Market on September 29, 2004. For our common stock to remain listed on the NASDAQ National Market, we must meet the minimum listing requirements for continued listing, including, among other requirements, minimum bid price and market value of public float requirements. If we fail to continue to meet the minimum listing requirements, we may be delisted from the NASDAQ National Market. If our common stock is delisted from the NASDAQ National Market, sales of our common stock would likely be conducted only in the over-the counter market. This may have a negative impact on the liquidity and the price of our common stock, and investors may find it more difficult to purchase or dispose of, or to obtain accurate quotations as to the market value of, our common stock. THE TRADING PRICE FOR OUR COMMON STOCK MAY DROP AND THIS COULD AFFECT YOUR ABILITY TO RESELL YOUR SHARES AT OR ABOVE THE PRICE YOU PAID TO PURCHASE SUCH SHARES. The stock market, in general, and the trading prices of shares in public technology companies, particularly those such as ours that offer Internet-based products and services, have experienced extraordinary price and volume volatility in recent years. Such volatility has adversely affected the stock prices for many companies irrespective of, or disproportionately to, the operating performance of these companies. Indeed, the trading price of our common stock dropped significantly during the year ended December 31, 2000, thereby precipitating our delisting from the NASDAQ National Market in March 2001. Alternatively, the trading price of our common stock rose significantly during the years ended December 31, 2003 and 2004, ultimately leading to our common stock being relisted on the NASDAQ National Market in September 2004. During the year ended December 31, 2005, the trading price of our common stock dropped significantly. We believe that these fluctuations in our stock prices could be the result of many factors, some of which are beyond our control, such as: our quarterly or annual results in operations; investor perception of us, online retailing services and retail store services in general; general economic conditions both in the United States and in foreign countries; adverse or favorable business developments; futures sales of substantial amounts of our common stock by our existing shareholders, officers or directors; failure to meet estimates or expectations of securities analysts or changes in financial estimates by securities analysts; and announcements by us or our competitors of new products and services. As a result of these factors, we cannot assure you that the trading price of our common stock will not drop again or stay at its current price. Market and industry factors may materially and adversely further affect the market price of our common stock, regardless of our actual operating performance. Significant decreases in the trading price of our common stock is likely to affect our visibility and credibility in our market and this could affect your ability to resell your shares at or above the price you paid to purchase such shares. IF OUR STOCK PRICE IS VOLATILE, WE MAY BECOME SUBJECT TO SECURITIES LITIGATION WHICH IS EXPENSIVE AND COULD RESULT IN A DIVERSION OF RESOURCES. Securities class action litigation has often been brought against companies that experience volatility in the market price of their securities. Litigation brought against us could result in substantial costs to us in defending against the lawsuit and a diversion of managements attention that could cause our business to be harmed. FUTURE SALES OF OUR COMMON STOCK MAY NEGATIVELY AFFECT OUR STOCK PRICE. The market price of our common stock could decline as a result of sales of a large number of shares of our common stock by our existing shareholders, officers or directors, or the perception that such sales could occur. These sales also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. IT MAY BE DIFFICULT FOR A THIRD PARTY TO ACQUIRE OUR COMPANY AND THIS COULD DEPRESS OUR STOCK PRICE. Delaware corporate law and our amended and restated certificate of incorporation and our by-laws contain provisions that could have the effect of delaying, deferring or preventing a change in control of Varsity Group or a change of our management that stockholders may consider favorable or beneficial. These provisions could discourage proxy contests and make it more difficult for you and other stockholders to elect directors and take other corporate actions. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions include those which: authorize the issuance of blank check preferred stock, which is preferred stock that can be created and issued by the board of directors without prior stockholder approval, with rights senior to those of common stock; provide for a staggered board of directors, so that it would take three successive annual meetings to replace all directors; prohibit stockholder action by written consent; and establish advance notice requirements for submitting nominations for election to the board of directors and for proposing matters that can be acted upon by stockholders at a meeting.