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FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: June 26, 2004 Commission file No. 0-15338
------------- -------
PHOTOWORKS, INC.
(Exact name of registrant as specified in its charter.)
Washington 91-0964899
------------------------------- ----------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1260 16th Avenue West, Seattle, WA 98119
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (206) 281-1390
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to the
filing requirements for the past 90 days.
Yes X No
--- ---
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act):
Yes No X
--- ---
As of July 30, 2004, there were issued and outstanding 16,850,041
shares of common stock, par value $.01 per share.
Index to Exhibits at Page 17
PHOTOWORKS, INC.
INDEX
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Page No.
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PART I -- FINANCIAL INFORMATION
Item 1 - Financial Statements 3-10
Consolidated Balance Sheets as of June 26, 2004
and September 27, 2003 3
Consolidated Statements of Operations for the third quarter
and nine months ended June 26, 2004 and June 28, 2003 4
Consolidated Statements of Cash Flows for the nine months
ended June 26, 2004 and June 28, 2003 5
Notes to Consolidated Financial Statements 6-10
Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations 11-15
PART II -- OTHER INFORMATION
Item 1 - Legal Proceedings 15
Item 6 - Exhibits and Reports on Form 8-K 15
SIGNATURES 16
INDEX TO EXHIBITS 17
CERTIFICATIONS 18-20
2
PART I -- FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
PHOTOWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
(UNAUDITED) (NOTE)
June 26, September27,
ASSETS 2004 2003
===========================
CURRENT ASSETS
Cash and cash equivalents $ 2,656 $ 4,756
Accounts receivable, net of allowance for doubtful accounts 130 28
Inventories 724 652
Prepaid expenses 222 354
-------- --------
TOTAL CURRENT ASSETS 3,732 5,790
Furniture, fixtures and equipment at cost, less accumulated depreciation 1,260 1,821
Long-term receivables 252 -
Lease deposits 34 51
-------- --------
TOTAL ASSETS $ 5,278 $ 7,662
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES
Accounts payable $ 1,416 $ 1,376
Accrued compensation 676 1,260
Other accrued expenses 477 588
ITC penalty, current portion 250 239
Current portion of capital lease obligations 2 2
Income taxes payable - 14
Deferred revenues 485 477
-------- --------
TOTAL CURRENT LIABILITIES 3,306 3,956
Subordinated convertible debentures 2,500 2,500
ITC penalty, non-current portion 666 636
Capital lease obligations, net of current portion 5 6
-------- --------
TOTAL LIABILITIES 6,477 7,098
SHAREHOLDERS' EQUITY (DEFICIT)
Preferred Stock, $.01 par value, authorized 2,000,000 shares,
issued and outstanding 15,000 shares - -
Common Stock, $.01 par value, authorized 101,250,000
shares, issued and outstanding 16,839,041 168 167
Additional paid-in capital 15,926 15,803
Accumulated deficit (17,293) (15,406)
-------- --------
TOTAL SHAREHOLDERS' EQUITY (DEFICIT) (1,199) 564
-------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 5,278 $ 7,662
======== ========
Note: The September 27, 2003 consolidated balance sheet has been derived from
audited consolidated financial statements. See accompanying notes to
consolidated financial statements.
3
PHOTOWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(in thousands, except share and per share data)
Third Quarter Ended Nine Months Ended
------------------------------ ------------------------------
June 26, June 28, June 26, June 28,
2004 2003 2004 2003
==============================================================================================================
Net revenues $ 4,690 $ 6,987 $ 14,998 $ 21,840
Cost of goods and services 3,441 4,939 11,202 16,894
------------ ------------ ------------ ------------
Gross profit 1,249 2,048 3,796 4,946
Operating expenses:
Marketing 694 543 1,833 1,955
Research and development 392 774 1,292 2,025
General and administrative 1,136 1,285 2,606 4,059
ITC penalty - 1,600 - 1,600
------------ ------------ ------------ ------------
Total operating expenses 2,222 4,202 5,731 9,639
------------ ------------ ------------ ------------
Loss from operations (973) (2,154) (1,935) (4,693)
Other income (expense):
Interest expense (58) (43) (175) (129)
Other income, net 59 17 108 37
------------ ------------ ------------ ------------
Total other income (expense), net 1 (26) (67) (92)
------------ ------------ ------------ ------------
Loss before income taxes (972) (2,180) (2,002) (4,785)
Income tax benefit (expense) 15 (25) 115 82
------------ ------------ ------------ ------------
Net loss $ (957) $ (2,205) $ (1,887) $ (4,703)
============ ============ ============ ============
Basic and diluted net loss per share $ (.06) $ (.13) $ (.11) $ (.28)
============ ============ ============ ============
Basic and diluted weighted average
shares outstanding 16,835,000 16,657,000 16,740,000 16,656,000
============ ============ ============ ============
See notes to consolidated financial statements.
4
PHOTOWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(in thousands)
Nine Months Ended
--------------------
June 26, June 28,
2004 2003
======================================================================================
OPERATING ACTIVITIES:
Net loss $(1,887) $(4,703)
Charges to income not affecting cash:
Depreciation and amortization 1,013 1,566
Vendor settlement (738) -
Stock-based compensation 115 -
Gain on disposal of furniture, fixtures and equipment (34) -
Imputed interest 33 -
Deferred revenues 8 53
Accrued ITC penalty - 1,600
Income taxes receivable/payable (15) 1,726
Net change in receivables, inventories, payables and other (185) 3,524
------- -------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES (1,690) 3,766
INVESTING ACTIVITIES:
Purchase of furniture, fixtures, and equipment (454) (263)
Proceeds from sales of furniture, fixtures and equipment 36 -
------- -------
NET CASH USED IN INVESTING ACTIVITIES (418) (263)
FINANCING ACTIVITIES:
Proceeds from issuance of Common Stock 9 1
Payments on capital lease obligation (1) (94)
------- -------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 8 (93)
------- -------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (2,100) 3,410
Cash and cash equivalents at beginning of period 4,756 1,175
------- -------
CASH AND CASH EQUIVALENTS
AT END OF PERIOD $ 2,656 $ 4,585
======= =======
Supplemental cash flow information
Cash paid for interest $ 88 $ 89
Cash received from income tax refund $ 100 $ 1,808
See notes to consolidated financial statements.
5
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE A - BASIS OF PRESENTATION
PHOTOWORKS, INC: ("PhotoWorks" or the "Company") is a full-service
photography services company dedicated to providing its customers with
innovative and inspiring ways to create, share and preserve their memories,
primarily through online and mail-order channels. The PhotoWorks(R) service
provides image printing and online image storage and management services for
both digital and film based camera users, primarily in the United States, which
allows customers to store and organize photos online, share them with friends
and family, and order prints, photo albums, and photo related products.
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Rule 10-01 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted in the United
States for complete financial statements. In the opinion of management, all
adjustments (consisting of normal recurring adjustments) considered necessary
for a fair presentation of interim results have been included. The Company
follows a policy of recording its interim periods and year-end on a 13-week
basis for comparability of results and to be consistent with its internal weekly
reporting. Operating results for the nine-months ended June 26, 2004 are not
necessarily indicative of the results that may be expected for the fiscal year
ending September 25, 2004. For further information, refer to the "Management's
Discussion and Analysis of Financial Condition and Results of Operations" under
Item 2 below and under Item 7 of Part II of the Company's Annual Report on Form
10-K for the year ended September 27, 2003 and the Company's consolidated
financial statements and footnotes thereto also included in the Company's Annual
Report.
NOTE B - LIQUIDITY
The Company has experienced significant revenue declines and has
incurred operating losses in recent years. For the first nine months of fiscal
2004, cash flow used in operations was $1,690,000, primarily attributable to a
net loss of $1,887,000. As compared to prior periods the net loss is primarily
due to lower revenues partially offset by lower operating costs. While cash
flows from operations were positive in fiscal 2003 and 2002, this was primarily
due to income tax refunds aggregating $5,780,000 related to net operating tax
loss carrybacks. Cash and cash equivalents declined from $4,756,000 at the
beginning of the fiscal year to $2,656,000 as of June 26, 2004 and the Company's
current ratio declined from 1.46 to 1.13. The Company expects a further decline
in cash and cash equivalents in the fourth quarter primarily due to a payment to
the International Trade Commission (see Note K), continued declines in film
revenues and the cost of initiatives to improve the online customer experience,
including a new Web site infrastructure and an enhanced product offering. Based
on current operating plans, management expects cash and cash equivalents of
approximately $1,500,000 at the end of the fourth quarter.
Management has taken various actions, including workforce reductions,
store closures, and reduced operating expenditures to more closely align its
cost structure with its reduced revenue levels and to improve its operating
margins and cash flows. Management believes its investments in technology and
marketing will offer consumers innovative and easy to use digital products and
services. The Company also expects to lower its costs through a combination of
technology upgrades and more efficient production and customer service
operations. However, the Company is subject to certain risks similar to other
companies serving the digital products and services market such as system
performance problems due to technical difficulties, competition from other
companies with possibly greater financial, technical, and marketing resources
and the risks of executing on the current business plan.
Management believes that, under its current operational plans, current
cash balances and future cash flows will be sufficient to fund its operations
through September 2005. Nonetheless, if the Company is not able to successfully
execute on its current business strategy there will be a material adverse impact
on the Company's financial position and liquidity that will require the Company
to further reduce its expenditures or seek additional capital to enable it to
continue operations for at least the next twelve months. The financial
statements do not include adjustments that might result from the uncertainty of
the Company's ability to execute on its current business strategy and its
ability to continue to fund its operations.
6
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE C - INVENTORIES
Inventories are stated at the lower of cost (using the first-in,
first-out method) or market. Inventories consist primarily of film and
photofinishing supplies. An inventory reserve is established based on the
valuation of the Company's inventory, and those inventories which are obsolete
or in excess of forecasted usage or their estimated net realizable value.
NOTE D - RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform to the
current year's presentation.
NOTE E - VENDOR SETTLEMENT
During the second quarter of fiscal 2004, the Company reached a
settlement agreement regarding disputed fees for services provided to the
Company, resulting in a $738,000 reduction to administrative expenses. The
settlement was recorded as a $398,000 reduction to accounts payable for
previously invoiced amounts and $340,000 as receivables, which represents the
proceeds to be received under the settlement agreement, net of a discount for
interest using a 6% discount rate. The receivable is due in annual installments
of $95,000 over the next four years.
NOTE F - PROPERTY AND LEASES
The Company negotiated a termination agreement for one of its two
leases for operating facilities, effective April 30, 2004. The lease formerly
expired in September 2005 and annual lease payments totaled approximately
$473,000 per year. As a result, management revised the estimated life of the
related leasehold improvements, resulting in additional depreciation charges to
cost of goods sold of approximately $80,000 for the quarter ended June 26, 2004.
NOTE G - DEFERRED REVENUES
At the end of fiscal 2003, the Company's deferred revenue was primarily
attributable to its Frequent Customer Program. Under this program, after
processing a certain number of rolls of film within a stated period of time, a
customer received free processing on their next roll of film. For each roll of
film for which the processing was paid under this program, the Company deferred
a portion of the revenue received and recognized the revenue upon processing of
the free roll, so that revenue from customers in this program was recognized
ratably over all rolls of film processed. The Frequent Customer Program expired
in January 2004.
During the fourth quarter of fiscal 2003, the Company launched its Pick
Your Prints service for film processing orders. Under this service, a customer's
images are digitized and only the negatives are initially mailed back. As part
of the initial transaction, a customer is issued one print credit per image
developed, which they can then use to purchase only the photos they want to have
printed. Prints are then produced utilizing the digital images. A portion of the
initial purchase is deferred equal to the relative fair value of the digital
prints. Revenue is recognized upon utilization of the print credits to order
digital prints. As of June 26, 2004, approximately $265,000 was deferred under
this program.
In November 2004, the Company began offering a prepaid print credit
product, whereby customers can buy online print credits to use on future digital
print orders. Amounts received for the purchase of these credits are deferred
and revenue is recognized upon fulfillment of digital print orders. As of June
26, 2004, approximately $140,000 was deferred under this program.
7
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE H - INCOME TAXES
During the third quarter of fiscal 2004, a tax benefit of $15,000
was recorded for a refund of federal income taxes recognized in fiscal 2003. The
Company has net deferred tax assets totaling $12,371,000, comprised primarily of
net operating loss carryforwards. Due to the recent history of operating losses,
the uncertainty of future taxable income, and limitations on the utilization of
net operating loss carryforwards under IRC Section 382, a valuation allowance of
$12,371,000 has been recorded against net deferred tax assets.
NOTE I - STOCK-BASED COMPENSATION
The Company has adopted the disclosure-only provisions of Statement of
Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based
Compensation," and SFAS No. 148, "Accounting for Stock-Based Compensation -
Transition Disclosures," and applies Accounting Principles Board Opinion No. 25
(APB 25) and related Interpretations in accounting for its stock option plans.
Accordingly, the Company's stock-based compensation expense is recognized based
on the intrinsic value of the option on the date of grant.
Pursuant to Stock Option Plans adopted in 1982 and 1987, options may be
granted to purchase up to 6,904,688 shares of Common Stock at prices equal to
the fair market value of the shares at the time the options are granted.
In October 1999, the Board of Directors adopted the PhotoWorks, Inc.
1999 Employee Stock Option Plan. Employees, consultants, independent
contractors, advisors and agents are eligible to participate in this plan.
Officers and directors are not eligible to participate. Pursuant to this plan,
options may be granted to purchase up to 800,000 shares of Common Stock at
prices equal to the fair market value of the shares at the time the options are
granted.
In February 2000, shareholders approved the 1999 Stock Incentive
Compensation Plan. Officers, directors, employees, consultants, independent
contractors, advisors and agents are eligible to participate in this plan.
Pursuant to this plan, options may be granted to purchase up to 2,300,000 shares
of Common Stock.
Under this plan, pursuant to an employment agreement with Mr. Philippe
Sanchez, the Company's President and CEO, the Company granted a stock option on
October 28, 2003, for 250,000 shares with an exercise price of $.01. Based on
the fair market value of $.70 on the date of grant, the Company will recognize
stock compensation expense of $172,500 ratably over the twelve-month vesting
period of the option grant.
Shares of Common Stock reserved for issuance under these stock option
plans totaled 4,093,084 at June 26, 2004, of which 616,845 shares were available
for options to be granted in the future. Options generally vest over three to
four years and become exercisable commencing one year after the date of grant
and expiring five to seven years after the date of grant.
In addition, as an incentive to employment, Mr. Sanchez was granted a
stock option for 750,000 shares at a price equal to fair market value on the
date of grant. These shares were granted outside of the above plans.
Pro forma information regarding net loss and net loss per share has
been determined as if the Company had accounted for its employee stock options
under the fair value method of SFAS No. 123. The fair value of the options was
estimated at the date of grant using a Black-Scholes option pricing model with
the following weighted-average assumptions on the option grant date:
June 26, 2004 June 28, 2003
================================================================================
Risk free interest rate 3.24% 1.51%
Expected volatility 182.95% 147.59%
Expected option life 3.04 years 3.13 years
Dividend yield 0.00% 0.00%
8
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE I - STOCK-BASED COMPENSATION (Continued)
Under Statement No. 123, if the Company had elected to recognize the
compensation cost based upon the fair value of the options at grant date, net
loss would have been increased as follows:
Third Quarter Ended Nine Months Ended
------------------------------ ------------------------------
June 26, 2004 June 28, 2003 June 26, 2004 June 28, 2003
================================================================
Net loss as reported $ (957,000) $(2,205,000) $(1,887,000) $(4,703,000)
Add: Stock-based compensation expense
included in net loss, net of related tax effects 43,000 - 115,000 -
Deduct: Stock-based compensation as determined
under SFAS No. 123, net of related tax effects (116,000) (89,000) (508,000) (357,000)
----------- ----------- ----------- -----------
Pro forma net loss $(1,030,000) $(2,294,000) $(2,280,000) $(5,060,000)
=========== =========== =========== ===========
Net loss per share as reported $ (.06) $ (.13) $ (.11) $ (.28)
=========== =========== =========== ===========
Pro forma net loss per share $ (.06) $ (.14) $ (.14) $ (.30)
=========== =========== =========== ===========
NOTE J - EARNINGS (LOSS) PER SHARE
Earnings per share is computed based on the weighted average number of
common shares and dilutive common stock equivalents outstanding during the
period. Convertible preferred shares, outstanding warrants and stock options to
purchase shares of common stock were excluded from the computations of net loss
per share because their effect was antidilutive.
The following table sets forth the computation of basic and diluted
loss per share:
Third Quarter Ended Nine Months Ended
------------------------------- -------------------------------
June 26, 2004 June 28, 2003 June 26, 2004 June 28, 2003
===============================================================================================================================
Numerator for basic and diluted earnings per share:
Net loss $ (957,000) $ (2,205,000) $ (1,887,000) $ (4,703,000)
============ ============ ============ ============
Denominator:
Denominator for basic earnings
per share - weighted-average shares 16,835,000 16,657,000 16,740,000 16,656,000
Effect of dilutive securities:
Options, warrants, convertible preferred shares - - - -
------------ ------------ ------------ ------------
Denominator for diluted earnings per share 16,835,000 16,657,000 16,740,000 16,656,000
============ ============ ============ ============
Net loss per share $ (.06) $ (.13) $ (.11) $ (.28)
============ ============ ============ ============
At June 26, 2004, and June 28, 2003 there were 8,296,335 and 7,230,790
stock options, warrants and common stock upon conversion of Series A preferred
shares, respectively, that were excluded from the computation of net loss per
share as their effect was antidilutive. If the Company had reported net income,
the calculation of these per share amounts would have included the dilutive
effect of these common stock equivalents using the treasury stock method.
9
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE K - ITC PENALTY
In September 2003, the Company negotiated a settlement agreement with
the International Trade Commission, whereby the Company pays $250,000 in July
for each of the next four years beginning in 2004. The Company accrued a penalty
amount of $875,000 ($1,000,000 million penalty net of imputed interest of
$125,000 at an estimated borrowing rate of 6%) in the fiscal 2003 financial
statements for this matter.
NOTE L - CONTINGENCIES
The Company was a defendant in a claim filed by Fuji Photo Film Co.,
Ltd. with the International Trade Commission. There is a risk that Fuji could
bring a civil action against the Company for damages for patent infringement by
reason of sales of cameras that have been found in the International Trade
Commission proceedings to infringe Fuji patents. If such a suit was filed
against the Company, it could have a significantly harmful impact on its
financial condition, results of operations and liquidity. The Company is unable
to determine the probability or likelihood of such an action.
The Company is also involved in various routine legal proceedings in
the ordinary course of its business.
NOTE M - SUBSEQUENT EVENT
On August 4, 2004, the Company completed a transaction structured as an
asset purchase, under which it acquired substantially all of the assets of
PhotoAccess Technologies Corporation ("PhotoAccess"). PhotoAccess provides
online digital camera photofinishing solutions for consumers and business
customers including retailers, professional photographers and newspapers. The
assets include PhotoAccess' fixed assets, customer list, and digital platform --
including back-end technologies for transaction processing, print fulfillment
workflow, customer service and billing.
In exchange for the assets, PhotoWorks assumed $150,000 of PhotoAccess'
liabilities and accrued expenses and issued 1,200,000 shares of PhotoWorks
common stock. The total cost of the acquisition is estimated to be approximately
$650,000, based on the fair value of PhotoWorks common stock of $.33, (the
average price of the common stock during a seven-day period beginning three
trading days before and ending three trading days after the public announcement
of the acquisition on April 21, 2004), the assumption of $150,000 of
PhotoAccess' liabilities, and related transaction costs of approximately
$100,000.
In addition, pursuant to the definitive agreement signed May 13, 2004,
PhotoWorks assumed fulfillment obligations for PhotoAccess' customer orders.
Revenues and fulfillment costs for orders received from PhotoAccess customers
have been included in PhotoWorks net revenues and cost of goods sold since May
1, 2004.
The acquisition is expected to be accounted for in the fourth quarter
of fiscal 2004 as a business combination. The total purchase price, as discussed
above, will be allocated to PhotoAccess' tangible and intangible assets, based
on their relative fair values as of August 4, 2004.
10
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Safe Harbor Statement under the Private Securities Litigation Reform Act of
1995:
This report contains forward-looking statements that relate to future
events, product or service offerings, or the future financial performance of the
Company. In some cases, you can identify forward-looking statements by
terminology such as "may," "will," "should," "expects," "plans," "anticipates,"
"believes," "estimates," "predicts," "potential," or "continue" or the negative
of such terms and other comparable terminology. These statements only reflect
Company management's expectations and estimates. Actual events or results may
differ materially from those expressed or implied by such forward-looking
statements due to a number of known and unknown risks and uncertainties. These
risks and uncertainties include the ability to generate cash to fund operating
activities or obtain additional funding, effective execution of product launches
or marketing programs, pricing and other activities by competitors, economic and
industry factors, system performance problems due to technical difficulties, and
other risks, including those described in the Company's Annual Report on Form
10-K and those described in the Company's other filings with the Securities and
Exchange Commission, press releases and other communications. Any
forward-looking statements in this report reflect the Company's expectations at
the time of this report only, and the Company disclaims any responsibility to
revise or update any such forward-looking statements except as may be required
by law.
General
PhotoWorks, Inc. ("PhotoWorks" or the "Company") is a full-service
photography services company dedicated to providing its customers with
innovative and inspiring ways to create, share and preserve their photographic
memories, primarily through online and mail-order channels. The PhotoWorks(R)
service provides image printing and online image storage and management services
for both digital and film based camera users, primarily in the United States,
which allows customers to store and organize photos online, share them with
friends and family, and order prints, photo albums, and photo related products.
PhotoWorks incurred a net loss of $1,887,000 ($.11 per share) during
the first nine months of fiscal 2004, compared to a net loss of $4,703,000 ($.28
per share) for the first nine months of 2003. Although revenues for the first
nine months of fiscal 2004 declined by approximately 31% compared to the same
period for fiscal 2003, the Company reduced its net loss through improved
operating efficiencies and lower operating costs. The 2004 net loss included the
benefit of a gain of $738,000 in the second quarter from the settlement of a
dispute with a vendor. The 2003 net loss included a charge of $1,600,000 in the
third quarter to record a penalty assessment.
Operating results may fluctuate in the future due to changes in the mix
of sales, marketing and promotional activities, introductions of new products,
research and development requirements, actions by competitors, price increases
or decreases by suppliers, conditions in the direct-to-consumer market and the
photofinishing industry in general, national and global economic and political
conditions, and other factors.
Demand for the Company's services is generally seasonal, producing the
highest volumes in the first and fourth quarters of the fiscal year. However,
seasonality of demand may be offset by changes in the effectiveness of marketing
programs, the introduction of new services and products, actions by competitors
and other factors. Operating results are affected by the seasonality of the
Company's net revenues due to the fixed nature of a portion of the Company's
operating expenses, seasonal variation in sales mix, and product development and
marketing expenditures.
Critical Accounting Policies
Management's Discussion and Analysis of Financial Condition and Results
of Operations discusses the Company's consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States. The preparation of these financial statements requires
management to make estimates and judgments that affect the reported amounts of
assets, liabilities, net revenue, and expenses. Management's estimates and
judgments are based upon the Company's historical experience, knowledge of
economic and market factors, and various other factors that are believed to be
relevant given the circumstances. Significant policies, methodologies,
estimates, and the factors used therein,
11
are reviewed on at least a quarterly basis with the Company's Audit Committee.
Actual results may differ from these estimates.
The following is a discussion of the estimates included in the
Company's financial statements that encompass matters of uncertainty, whereby
different estimates could have reasonably been made or changes in such estimates
could have a material impact on the financial statements of the Company.
Reserve for Obsolete Inventory
We regularly assess the valuation of our inventory and write down those
inventories that are obsolete, or in excess of forecasted usage, to their
estimated realizable value. A reserve for obsolescence is recorded against
inventory for any film or paper inventories that are nearing their expiration
dates. Additional reserves are recorded for slow-moving or discontinued stock to
the extent it is estimated the materials may go unused based on historical
inventory turnover, planned changes in marketing promotions or other anticipated
changes in product mix over the next year, seasonality, or other factors.
Estimates of future usage are based on estimates of future sales and product
mix. If actual sales or product mix differs from our estimates, we may need to
record additional reserves for obsolete inventory.
Revenue Recognition
We recognize revenue when products are shipped or services are
delivered. PhotoWorks provides its customers with a 100% satisfaction guarantee.
The majority of the Company's products and services will not be returned but
customers can request a refund if not satisfied. During fiscal year 2003,
refunds were less than 1% of net revenues. An allowance is recorded for expected
future returns.
During the fourth quarter of fiscal 2003, we launched our Pick Your
Prints service for film processing orders. Under this service, a customer's
images are digitized and only the negatives are initially mailed back. As part
of the initial transaction, a customer is issued one print credit per image
developed, which they can then use to purchase only the photos they want to have
printed. Prints are then produced utilizing the digital images. A portion of the
initial purchase is deferred equal to the relative fair value of the digital
prints. Revenue is recognized upon utilization of the print credits to order the
digital prints. As of June 26, 2004, approximately $265,000 was deferred under
this program.
In November 2004, we began offering a prepaid print credit product,
whereby customers can buy online digital print credits to use on future print
orders. Amounts received for the purchase of these credits are deferred and
revenue is recognized upon fulfillment of digital print orders. As of June 26,
2004, approximately $140,000 was deferred under this program.
Deferred Tax Assets
We have net deferred tax assets totaling $12,371,000, comprised
primarily of net operating loss carryforwards. Due to our recent history of
operating losses, the uncertainty of future taxable income, and limitations on
the utilization of net operating loss carryforwards under IRC Section 382, we
have recorded a valuation allowance of $12,371,000 against our net deferred tax
assets.
Contingencies
We are subject to various legal proceedings and claims (see Part II,
Item 1 - Legal Proceedings and Note L of Notes to Consolidated Financial
Statements), the outcomes of which are subject to significant uncertainty. SFAS
No. 5, Accounting for Contingencies, requires that estimated amounts relating to
a contingency should be recorded if it is probable that a liability or gain has
been incurred and the amount can be reasonably estimated. Disclosure of a loss
contingency is required if there is at least a reasonable possibility that a
loss may have been incurred. We evaluate, among other factors, the degree of
probability of the outcome and the ability to make a reasonable estimate of the
amounts.
12
Results of Operations
The following table presents information from the Company's
consolidated statements of operations, expressed as a percentage of net revenues
for the periods indicated.
Third Quarter Ended Nine Months Ended
---------------------- ----------------------
June 26, June 28, June 26, June 28,
2004 2003 2004 2003
=======================================================================================
Net revenues 100.0% 100.0% 100.0% 100.0%
Cost of goods and services 73.4 70.7 74.7 77.4
----- ----- ----- -----
Gross profit 26.6 29.3 25.3 22.6
Operating expenses:
Marketing 14.8 7.7 12.2 8.9
Research and development 8.3 11.1 8.6 9.3
General and administrative 24.2 18.4 17.4 18.6
ITC penalty - 22.9 - 7.3
----- ----- ----- -----
Total operating expenses 47.3 60.1 38.2 44.1
----- ----- ----- -----
Loss from operations (20.7) (30.8) (12.9) (21.5)
Total other expense - (.4) (.5) (.4)
----- ----- ----- -----
Loss before income taxes (20.7) (31.2) (13.4) (21.9)
Income tax benefit (expense) .3 (.4) .8 .4
----- ----- ----- -----
Net loss (20.4)% (31.6)% (12.6)% (21.5)%
===== ===== ===== =====
Net revenues for the third quarter of fiscal 2004 were $4,690,000,
compared to net revenues of $6,987,000 in the third quarter of fiscal 2003. For
the nine months ended June 26, 2004, net revenues were $14,998,000 compared to
$21,840,000 for the same period of fiscal 2003. The decline in net revenues was
primarily due to continued lower film processing volumes, partially offset by
growth in digital printing services. Digital revenues in the third quarter of
fiscal 2004 increased 12.0% to $642,000 compared to $573,000 in the third
quarter of fiscal 2003. Year to date revenues from digital products and services
increased 15.3% to $2,193,000 compared to $1,902,000 for the same period of
fiscal 2003. In addition, net revenues in fiscal 2003 included approximately
$911,000 from sales generated at retail stores, which were closed by the end of
fiscal 2003 in order to focus resources on digital and online initiatives. Net
revenues in fiscal 2004 are expected to be lower than fiscal 2003 due to lower
film processing volumes.
Cost of goods and services consists of labor, processing materials and
supplies, shipping and handling costs and fixed operating costs related to the
Company's services and products. Gross profit in the third quarter of fiscal
2004 decreased to 26.6% of net revenues compared to 29.3% of net revenues in the
third quarter of fiscal 2003. For the first nine months of fiscal 2004, gross
profit increased to 25.3% compared to 22.6% for the same period of fiscal 2003.
The decrease for the third quarter was primarily due to lower revenues over
certain relatively fixed overhead costs associated with equipment and
facilities. The increase in the gross margin year to date was primarily due to
lower labor and materials costs, partially offset by approximately $320,000 of
additional depreciation charges related to a negotiated lease termination (see
Note F in Notes to Consolidated Financial Statements). Margins on certain
digital print services also increased due to higher selling prices in the first
and second quarters of fiscal 2004 as compared to the first two quarters of
fiscal 2003. Gross profit fluctuates due to the seasonal nature of revenues when
measured against relatively fixed overhead costs associated with equipment and
facilities.
Marketing expenses in the third quarter of fiscal 2004 were $694,000
compared to $543,000 in the third quarter of fiscal 2003. For the first nine
months of fiscal 2004, marketing expenses decreased to $1,833,000 compared to
$1,955,000 for the same period in fiscal 2003. Marketing expenditures in fiscal
2004 have been focused on developing new programs for acquiring new customers
and customer retention opportunities through enhanced customer relationship
management capabilities. Marketing expenses will fluctuate due to the timing and
magnitude of promotional activities and product and service introductions.
13
Research and development expenses decreased to $392,000 for the third
quarter of fiscal 2004 compared to $774,000 in the third quarter of fiscal 2003.
For the first nine months of fiscal 2004, research and development expenses
decreased to $1,292,000 as compared to $2,025,000 for the same period of fiscal
2003. In fiscal 2003, the Company incurred costs related to the development of
its PhotoWorks Digital Partner software product. We expect continued investment
in research and development as we rebuild our technology infrastructure and
develop a new Web site and enhanced product line.
General and administrative expenses decreased to $1,136,000 for the
third quarter of fiscal 2004 compared to $1,285,000 for the third quarter of
fiscal 2003. Expenses in the third quarter of fiscal 2004 include approximately
$100,000 related to the PhotoAccess transaction (see Note M of Notes to
Consolidated Financial Statements). For the nine months ended June 26, 2004,
general and administrative expenses decreased to $2,606,000 compared to
$4,059,000 for the same period of fiscal 2003. During the second quarter of
fiscal 2004, PhotoWorks, Inc. and one of its service providers reached a
settlement agreement regarding disputed fees for services provided to
PhotoWorks, resulting in a reduction of administrative expenses of $738,000. In
addition, the quarter and year to date expenses were lower due to reduced
staffing and professional service costs. General and administrative expenses
consist of costs related to management information systems, computer operations,
human resource functions, finance, legal, accounting, investor relations and
general corporate activities.
Operating expenses for fiscal 2003 included a $1,600,000 penalty
assessment by the ITC that was recorded in the third quarter of fiscal 2003 (see
Note K of Notes to Consolidated Financial Statements).
Other income in the third quarter of fiscal 2004 consists of
interest income of approximately $30,000 related to a tax refund received for
additional credit available from NOL carrybacks in fiscal 2001 and 2002,
partially offset by interest expense for the quarter.
Liquidity and Capital Resources
The Company has experienced significant revenue declines and has
incurred operating losses in recent years. For the first nine months of fiscal
2004, cash flow used in operations was $1,690,000, primarily attributable to a
net loss of $1,887,000. As compared to prior periods the net loss is primarily
due to lower revenues partially offset by lower operating costs. While cash
flows from operations were positive in fiscal 2003 and 2002, this was primarily
due to income tax refunds aggregating $5,780,000 related to net operating tax
loss carrybacks. Cash and cash equivalents declined from $4,756,000 at the
beginning of the fiscal year to $2,656,000 as of June 26, 2004 and the Company's
current ratio declined from 1.46 to 1.13. The Company expects a further decline
in cash and cash equivalents in the fourth quarter primarily due to a payment to
the International Trade Commission (see Note K of Notes to Consolidated
Financial Statements), continued declines in film revenues and the cost of
initiatives to improve the online customer experience, including a new Web site
infrastructure and an enhanced product offering. In addition, the Company
completed a transaction to purchase assets of PhotoAccess Technologies (See Note
M - Subsequent Event of Notes to Consolidated Financial Statements in Part I
above).
As of July 30, 2004, the Company's principal source of liquidity
included approximately $2,400,000 in cash and cash equivalents. Based on current
operating plans, management expects cash and cash equivalents of approximately
$1,500,000 at the end of the fourth quarter.
Management has taken various actions, including workforce reductions,
store closures, and reduced operating expenditures to more closely align its
cost structure with its reduced revenue levels and to improve its operating
margins and cash flows. Management believes its investments in technology and
marketing will offer consumers innovative and easy to use digital products and
services. The Company also expects to lower its costs through a combination of
technology upgrades and more efficient production and customer service
operations. However, the Company is subject to certain risks similar to other
companies serving the digital products and services market such as system
performance problems due to technical difficulties, competition from other
companies with possibly greater financial, technical, and marketing resources
and the risks of executing on the current business plan.
14
Management believes that, under its current operational plans, current
cash balances and future cash flows will be sufficient to fund its operations
through September 2005. Nonetheless, if the Company is not able to successfully
execute on its current business strategy there will be a material adverse impact
on the Company's financial position and liquidity that will require the Company
to further reduce its expenditures or seek additional capital to enable it to
continue operations for at least the next twelve months. The financial
statements do not include adjustments that might result from the uncertainty of
the Company's ability to execute on its current business strategy and its
ability to continue to fund its operations.
Controls and Procedures
At the end of the period covered by this report, as part of our
quarterly review, we evaluated, under the supervision and with the participation
of the Company's management, including our Chief Executive Officer and Chief
Accounting Officer, the effectiveness of the design and operation of our
disclosure controls and procedures pursuant to Exchange Act Rule 13a-14 and
15d-14. Based upon that evaluation, the Chief Executive Officer and the Chief
Accounting Officer concluded that our disclosure controls and procedures are
effective to timely alert them to any material information relating to the
Company (including its consolidated subsidiaries) that must be included in our
periodic SEC filings. There have been no significant changes in the Company's
internal controls or in other factors that could significantly affect internal
controls subsequent to their evaluation.
PART II -- OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS
For an update concerning legal proceedings, see Note L of Notes to
Consolidated Financial Statements in Part I above.
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
10.1 Third Amendment to Lease dated June 29, 2004 with Immunex
Corporation.
31.1 Certification Pursuant to Rule 13a-14 of the Securities
Exchange Act of 1934 as Adopted Pursuant to Section 302 of
the Sarbannes-Oxley Act of 2002
31.2 Certification Pursuant to Rule 13a-14 of the Securities
Exchange Act of 1934 as Adopted Pursuant to Section 302 of
the Sarbannes-Oxley Act of 2002
32 Certification of Principal Executive Officers pursuant to
18 U.S.C Section 1350, as Adopted Pursuant to Section 906
of the Sarbannes-Oxley Act of 2002
(b) Reports on Form 8-K.
Form 8-K dated April 21, 2004 - Item 12 - Results of
Operations and Financial Condition for second quarter ended
March 27, 2004.
15
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PHOTOWORKS, INC.
DATED: August 10, 2004 /s/ Philippe Sanchez
-------------------------------------
Philippe Sanchez
Chief Executive Officer and Chairman
(Principal Executive Officer)
/s/ Loran Cashmore Bond
-------------------------------------
Loran Cashmore Bond
Vice President Administration
Treasurer/Chief Accounting Officer
16
INDEX TO EXHIBITS
PHOTOWORKS, INC.
Quarterly Report on Form 10-Q
For The Quarter Ended June 26, 2004
Exhibit Description
------- -----------
3.1 Third Amended and Restated Articles of Incorporation dated January
27, 1998. (Incorporated by reference to Form 10-K/A for the year
ended September 25, 1999, filed January 14, 2000.)
3.2 Articles of Amendment to Articles of Incorporation dated January 25,
2000. (Incorporated by reference from Form 10-Q for the quarter
ended December 25, 1999.)
3.3 Articles of Amendment to Articles of Incorporation of PhotoWorks,
Inc. dated February 9, 2000 (Incorporated by reference to Exhibit
3.1 filed with the Company's 8-K filed February 16, 2000)
3.4 Articles of Amendment to Articles of Incorporation of PhotoWorks,
Inc. dated April 24, 2001 (Incorporated by reference to Exhibit 3.1
filed with the Company's 8-K filed April 27, 2001)
3.5 Articles of Correction to Articles of Incorporation of PhotoWorks,
Inc. dated April 25, 2001 (Incorporated by reference to Exhibit 3.2
filed with the Company's 8-K filed April 27, 2001)
3.6 Form of Certificate of Designation Preferences and Rights of Series
RP Preferred Stock (Incorporated by reference to Exhibit 3.4 to the
Company's Annual Report on 10-K for the year ended September 25,
1999)
3.7 Bylaws of the Company, as amended and restated on November 13, 1996.
(Incorporated by reference to Exhibit 3.2 filed with the Company's
Annual Report on Form 10-K for the year ended September 28, 1996)
4.1 Rights Agreement dated December 16, 1999 between the Registrant and
Chase Mellon Shareholder Services L.L.C., as Rights Agent
(Incorporated by reference to Exhibit 4.1 to the current report on
Form 8-K filed with the Commission on December 17, 1999)
10.1* Third Amendment to Lease dated June 29, 2004 with Immunex
Corporation.
31.1* Certification Pursuant to Rule 13a-14 of the Securities Exchange Act
of 1934 as Adopted Pursuant to Section 302 of the Sarbannes-Oxley
Act of 2002
31.2* Certification Pursuant to Rule 13a-14 of the Securities Exchange Act
of 1934 as Adopted Pursuant to Section 302 of the Sarbannes-Oxley
Act of 2002
32* Certification of Principal Executive Officers pursuant to 18 U.S.C
Section 1350, as Adopted Pursuant to Section 906 of the
Sarbannes-Oxley Act of 2002
* Filed herewith
17