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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
_X_ Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the quarterly period ended September 30, 2004
or
___ Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from ________ to _________.
Commission File No. 0-21527
MEMBERWORKS INCORPORATED
(Exact name of registrant as specified in its charter)
DELAWARE 06-1276882
- ------------------------ ----------------
(State of Incorporation) (IRS Employer
Identification No.)
680 Washington Boulevard
Stamford, Connecticut 06901
- --------------------------------------- ----------------
(Address of principal executive offices) (Zip Code)
(203) 324-7635
---------------------------------
(Registrant's telephone number,
including area code)
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 such 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 Act).
[X] Yes [ ] No
Indicate the number of shares outstanding of each of the registrant's class of
common stock as of the latest practicable date: 10,002,792 shares of Common
Stock, $0.01 par value as of October 29, 2004.
MEMBERWORKS INCORPORATED
INDEX TO FORM 10-Q
PART I. FINANCIAL INFORMATION PAGE
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets as of September 30, 2004
and June 30, 2004 1
Condensed Consolidated Statements of Operations for the three
months ended September 30, 2004 and 2003 2
Condensed Consolidated Statements of Cash Flows for the three
months ended September 30, 2004 and 2003 3
Notes to Condensed Consolidated Financial Statements 4
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 15
Forward Looking Statements 20
Item 3. Quantitative and Qualitative Disclosures about Market Risk 22
Item 4. Controls and Procedures 22
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 24
Item 2. Changes in Securities and Use of Proceeds and Issuer
Purchases of Equity Securities 25
Item 6. Exhibits 25
Signatures 26
MEMBERWORKS INCORPORATED
CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(In thousands, except per share amounts)
September 30, June 30,
2004 2004
------------- -------------
Assets
Current assets:
Cash and cash equivalents $ 151,965 $ 159,496
Restricted cash 2,117 3,120
Short-term investments 15,549 7,650
Accounts receivable (net of allowance for doubtful accounts of $236 and $235 at
September 30, 2004 and June 30, 2004, respectively) 9,960 10,557
Prepaid membership materials 3,370 3,233
Prepaid expenses and other current assets 6,497 4,886
Membership solicitation and other deferred costs 46,240 52,428
------------- -------------
Total current assets 235,698 241,370
Fixed assets, net 34,057 36,540
Goodwill 126,586 125,675
Intangible assets, net 37,681 38,872
Other assets 10,864 10,705
------------- -------------
Total assets $ 444,886 $ 453,162
============= =============
Liabilities and Shareholders' Deficit
Current liabilities:
Current maturities of long-term obligations $ 335 $ 338
Accounts payable 32,699 35,185
Accrued liabilities 69,629 66,075
Deferred revenues 122,326 138,381
Deferred income taxes 10,495 12,323
------------- -------------
Total current liabilities 235,484 252,302
Deferred income taxes 10,655 4,354
Other long-term liabilities 4,893 4,930
Long-term debt 237,696 237,659
------------- -------------
Total liabilities 488,728 499,245
------------- -------------
Commitments and contingencies (Note 9) - -
Shareholders' deficit:
Preferred stock, $0.01 par value -- 1,000 shares authorized; no shares issued - -
Common stock, $0.01 par value -- 40,000 shares authorized;
19,155 shares issued (19,089 shares at June 30, 2004) 191 191
Capital in excess of par value 157,505 156,457
Accumulated earnings (deficit) 17,727 10,131
Accumulated other comprehensive loss 474 (373)
Treasury stock, 9,131 shares at cost (8,852 shares at June 30, 2004) (219,739) (212,489)
------------- -------------
Total shareholders' deficit (43,842) (46,083)
------------- -------------
Total liabilities and shareholders' deficit $ 444,886 $ 453,162
============= =============
The accompanying notes are an integral part of
these consolidated financial statements.
1
MEMBERWORKS INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(In thousands, except per share amounts)
Three Months Ended
September 30,
-----------------------------
2004 2003
------------- -------------
Revenues $ 135,623 $ 113,824
Expenses:
Marketing 68,532 66,656
Operating 24,210 21,463
General and administrative 24,605 18,767
Amortization of intangibles 1,544 318
------------- -------------
Operating income 16,732 6,620
Interest (expense) income, net (4,643) 33
Other expense, net (135) (162)
------------- -------------
Income before income taxes 11,954 6,491
Provision for income taxes 4,358 2,596
------------- -------------
Net income $ 7,596 $ 3,895
============= =============
Basic earnings per share $ 0.75 $ 0.33
============= =============
Diluted earnings per share $ 0.65 $ 0.30
============= =============
Weighted average common shares used in earnings per share calculations:
Basic 10,174 11,627
============= =============
Diluted 12,949 13,011
============= =============
The accompanying notes are an integral part of
these consolidated financial statements.
2
MEMBERWORKS INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)
Three Months Ended
September 30,
-----------------------------
2004 2003
------------- -------------
Operating activities
Net income $ 7,596 $ 3,895
Adjustments to reconcile net income to net cash provided
by operating activities:
Change in deferred revenues (16,335) (13,662)
Change in membership solicitation and other deferred costs 6,348 9,221
Depreciation and amortization 5,031 2,761
Deferred and other income taxes 3,105 835
Tax benefit from employee stock plans 129 1,515
Other 822 752
Change in assets and liabilities:
Restricted cash 1,003 204
Accounts receivable 597 (358)
Prepaid membership materials (137) 78
Prepaid expenses (1,220) 2,475
Other assets (14) 22
Accounts payable (2,468) (3,607)
Accrued and other liabilities 3,452 (6,149)
------------- -------------
Net cash provided by (used in) operating activities 7,909 (2,018)
------------- -------------
Investing activities
Acquisition of fixed assets (719) (921)
Purchase of short-term investments (8,193) -
Other investing activities 304 -
------------- -------------
Net cash used in investing activities (8,608) (921)
------------- -------------
Financing activities
Net proceeds from issuance of stock 919 22,089
Treasury stock purchases (7,250) (56,352)
(Debt issuance costs) net proceeds from issuance of debt (583) 87,019
Payments of long-term obligations (90) (67)
------------- -------------
Net cash (used in) provided by financing activities (7,004) 52,689
------------- -------------
Effect of exchange rate changes on cash and cash equivalents 172 2
------------- -------------
Net (decrease) increase in cash and cash equivalents (7,531) 49,752
Cash and cash equivalents at beginning of year 159,496 72,260
------------- -------------
Cash and cash equivalents at end of year $ 151,965 $ 122,012
============= =============
The accompanying notes are an integral part of
these consolidated financial statements.
3
MEMBERWORKS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE 1 - NATURE OF BUSINESS
MemberWorks Incorporated (the "Company"), a Delaware Corporation, began doing
business as Cardmember Publishing Corporation in 1986, was organized as
MemberWorks Incorporated in 1996 and has been doing business as MemberWorks
Incorporated since that time. On October 13, 2004, the Company began doing
business as Vertrue Incorporated. The name change was intended to reflect the
ever-broadening base of membership services that the Company offers to its
customers. The Company is a category leader in both membership and loyalty
programs. The Company's membership programs are both subscription and
transaction based offerings focused on meeting consumer needs in large spending
categories - healthcare, discounts, security and personals. The Company's
programs offer everyday savings, event-oriented discounts, peace of mind and
unique consumer benefits. Programs are available in English, French and Spanish
and are increasingly customized for specific client customer segments or
consumer communities. The Company's loyalty programs provide clients with a wide
range of benefits to offer or market to their customers and include stand-alone
benefits, reward point accumulation and management, gift certificate,
merchandise and travel reward redemption. The Company's versatility in designing
loyalty strategies and providing turnkey execution is essential in supporting
and promoting the client's brand.
NOTE 2 - BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States of America for interim financial information. Accordingly, such
statements do not include all of the information and footnotes required by
generally accepted accounting principles for complete financial statements. In
the opinion of management, all adjustments (consisting of normal recurring
adjustments) considered necessary for a fair presentation have been included.
The preparation of these consolidated financial statements in conformity with
generally accepted accounting principles requires management of the Company to
make estimates, judgments and assumptions that affect the amounts reported in
the financial statements and accompanying notes. Actual results could differ
from those estimates. Operating results for the three months ended September 30,
2004 are not necessarily indicative of the results that may be expected for the
fiscal year ending June 30, 2005. For further information, refer to the
financial statements and footnotes thereto included in the Company's Annual
Report on Form 10-K with respect to the fiscal year ended June 30, 2004.
The consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America and
include the accounts of the Company and its wholly-owned subsidiaries. All
significant intercompany accounts and transactions have been eliminated.
On April 1, 2004, the Company acquired Lavalife Inc. Therefore, the results of
operations of Lavalife Inc. have been included in the consolidated results of
operations since the date of acquisition and are not included in the results of
operations for the three months ended September 30, 2003.
NOTE 3 - RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform to the current year
presentation.
4
MEMBERWORKS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE 4 - STOCK-BASED COMPENSATION
In accordance with Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees" ("APB 25"), the Company applies the intrinsic value
method in accounting for employee stock options. Accordingly, the Company
generally does not recognize compensation expense with respect to stock-based
awards to employees. If compensation cost for the Company's stock-based
compensation plans had been determined based on the fair value (estimated using
the Black-Scholes option-pricing model) at the grant dates for awards under
those plans consistent with the method of Financial Accounting Standards Board
Statement ("SFAS") No. 123, "Accounting for Stock-Based Compensation" ("SFAS
123"), and SFAS No. 148, "Accounting for Stock-Based Compensation Transition and
Disclosure" ("SFAS 148"), the Company's pro forma net income and earnings per
share would have been as follows:
Three Months Ended
September 30,
----------------------
2004 2003
----------------------
Net income reported $ 7,596 $ 3,895
Add: Stock-based employee compensation expense determined under the
intrinsic value based method for all awards, net of related tax - -
effects
Deduct: Stock-based employee compensation expense determined under the
fair value based method for all awards, net of related tax effects 979 1,265
--------- ---------
Pro forma net income $ 6,617 $ 2,630
========= =========
Earnings per share:
As reported:
Basic $ 0.75 $ 0.33
Diluted $ 0.65 $ 0.30
Pro forma:
Basic $ 0.65 $ 0.23
Diluted $ 0.56 $ 0.20
NOTE 5 - GOODWILL AND OTHER INTANGIBLE ASSETS
The gross carrying value and accumulated amortization of goodwill and other
intangibles are as follows (in thousands):
As of September 30, 2004 As of June 30, 2004
------------------------------ ----------------------------
Gross Gross
Carrying Accumulated Carrying Accumulated
Amount Amortization Amount Amortization
------------ ------------ ----------- ------------
Amortizable intangible assets:
Membership and client relationships $ 27,994 $ (9,889) $ 27,999 $ (8,686)
Trade name 18,543 (618) 18,543 (310)
Other 1,520 (919) 1,162 (886)
------------ ------------ ----------- ------------
Total amortizable intangible assets 48,057 (11,426) 47,704 (9,882)
------------ ------------ ----------- ------------
Amortizable intangible assets, net $ 36,631 $ 37,822
============ ===========
Unamortizable intangible assets:
Goodwill $ 126,586 $ 125,675
Intangible asset related to minimum
pension liability $ 1,050 $ 1,050
The future intangible amortization expense for the next five years is estimated to be as follows (in thousands):
Fiscal Year
2005 $ 6,331
2006 6,062
2007 5,195
2008 3,175
2009 2,754
5
MEMBERWORKS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The changes in the carrying amount of goodwill for the three months ended
September 30, 2004 are as follows (in thousands):
Balance at June 30, 2004 $ 125,675
Arising from purchase price adjustments 911
----------
Balance at September 30, 2004 $ 126,586
==========
Goodwill was tested for impairment during the quarters ended September 30, 2004
and 2003 as required by SFAS 142. The Company concluded that none of its
goodwill was impaired. Fair value was estimated using a discounted cash flow
method. In addition, the Company reassessed the estimated useful lives of its
indefinite lived intangible assets and determined that the lives were
appropriate. The Company will continue to test the goodwill of each of its
reporting units annually or more frequently if impairment indicators exist.
NOTE 6 - FOREIGN CURRENCY INSTRUMENTS
The Company uses purchase option contracts and forward contacts to minimize its
exposure to changes in future cash flows caused by movements in foreign currency
exchange rates between the US dollar and the Canadian dollar. Derivatives are
held only for the purpose of hedging such risks and are not used for speculative
purposes. Derivatives used to hedge forecasted transactions and specific cash
flows associated with Canadian dollar denominated financial assets and
liabilities that meet the criteria for hedge accounting are designated as cash
flow hedges. The effective portion of gains and losses is deferred as a
component of accumulated other comprehensive income and is recognized in
earnings in the same line item as the underlying hedged item at the time the
hedged item affects earnings.
The fair value of these contracts is included in prepaid and other current
assets and the related gains and losses were recorded in operating expenses and
general administrative expenses and amounted to $44,000 for the quarter ended
September 30, 2004. As of September 30, 2004, the fair value of these
instruments was $862,000 (asset). All forecasted transactions currently being
hedged are expected to occur over the next twelve months. There were no such
instruments utilized during the quarter ended September 30, 2003.
NOTE 7 - ALLOWANCE FOR MEMBERSHIP CANCELLATIONS
Accrued liabilities set forth in the accompanying condensed consolidated balance
sheets as of September 30, 2004 and June 30, 2004 include an allowance for
membership cancellations of $12,017,000 and $14,156,000, respectively. Recording
an allowance for membership cancellations has the effect of reducing the amount
of deferred membership fees recorded.
NOTE 8 - RESTRUCTURING CHARGES
The restructuring reserve balance, which is recorded in accrued liabilities and
other long-term liabilities, amounted to $1,596,000 and $1,644,000 as of
September 30, 2004 and June 30, 2004, respectively. Cash payments for the
quarter ended September 30, 2004 were $48,000 and relate to lease obligations.
NOTE 9 - COMMITMENTS AND CONTINGENCIES
The Company operates in leased facilities. Management expects that leases
currently in effect will be renewed or replaced by other leases of a similar
nature and term.
On March 25, 2004, the Company entered into an amended and restated senior
secured credit facility that allows borrowings of up to $45,000,000. Borrowings
under the senior secured credit facility accrue interest at either the
Eurodollar rate, or the higher of the Prime rate or the Federal Funds rate, plus
an applicable margin. The availability under the senior secured credit facility
is reduced by an outstanding letter of credit of $5,459,000 and by one years'
worth of interest on the Senior Notes. There were no borrowings outstanding
under this bank credit facility as of September 30, 2004. As of September 30,
2004, the availability under the senior secured credit facility is $25,663,000.
Legal proceedings
Except as set forth below, in management's opinion, there are no significant
legal proceedings to which the Company or any of its subsidiaries is a party or
to which any of their properties are subject. The Company is involved in other
lawsuits and claims generally incidental to its business including, but not
limited to, various suits, including previously disclosed suits, brought against
the Company by individual consumers seeking monetary and/or injunctive relief
relating to the marketing of the Company's programs. In addition, from time to
time, and in the regular course of its business, the Company receives inquiries
from various federal and/or state regulatory authorities.
6
MEMBERWORKS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
On October 21, 2003, the Florida Attorney General's Office filed a civil
complaint against the Company based upon concerns that some of its past
marketing practices may have violated various consumer laws. On June 28, 2004,
the Company announced that it had reached a voluntary settlement with the
Florida Attorney General's office to alleviate these concerns. In connection
with the settlement, the Company agreed to formalize its existing national Best
Marketing Practices in the state of Florida and to pay the state of Florida
costs of investigation of $950,000. The Company expects that the agreement will
have little new effect on its business in Florida as the agreement serves to
formalize the Company's already existing national marketing best practices in
the state.
On January 24, 2003, the Company filed a motion with the Superior Court for the
Judicial District of Hartford, Connecticut to vacate and oppose the confirmation
of an arbitration award issued in December 2002. The arbitration, filed against
the Company by MedValUSA Health Programs, Inc. ("MedVal") in September 2000,
involved claims of breach of contract, breach of the duty of good faith and fair
dealing, and violation of the Connecticut Unfair Trade Practices Act ("CUTPA").
Even though the arbitrators found that the Company was not liable to MedVal for
any compensatory damages, they awarded $5,495,000 in punitive damages and costs
against the Company solely under CUTPA. The Company believes that this
arbitration award is unjustified and not based on any existing legal precedent.
Specifically, the Company is challenging the award on a number of grounds,
including that it violates a well defined public policy against excessive
punitive damage awards, raises constitutional issues and disregards certain
legal requirements for a valid award under CUTPA. The hearing on the Company's
motion was held on February 10, 2003. On June 22, 2003, the Superior Court
denied the Company's motion to vacate the award, and the Company filed an appeal
of that decision. While the Company intends to take action to prevent the
enforcement of the award by, among other things, vigorously pursuing an appeal,
there can be no assurance that the Company will be successful in its efforts.
The Company has made no provision in its financial statements for this
contingency because it believes that a loss is not probable. If the Company was
ultimately unsuccessful in this or other available appeals, and a final
non-appealable court order confirming the arbitration award is rendered, the
payment of the award could have a material adverse effect on the Company's
results of operations in the period in which the final order is entered.
In March 2001, an action was instituted by plaintiff Teresa McClain against
Coverdell & Company ("Coverdell"), a wholly-owned subsidiary of the Company,
Monumental Life Insurance Company and other defendants in the United States
District Court for the Eastern District of Michigan, Southern Division. The
suit, which seeks unspecified monetary damages, alleges that Coverdell and the
other defendants violated the Michigan Consumer Protection Act and other
applicable Michigan laws in connection with the marketing of Monumental Life
Insurance Company insurance products. The Court certified a class of Michigan
residents. The Court has now signed an Order granting preliminary approval of a
settlement agreement that has been signed by all parties. The Court will hold
the Fairness/Approval hearing on November 22, 2004. The settlement agreement
will have no financial or other material impact on the Company's business.
NOTE 10 - INCOME TAX EXPENSE
Income tax expense as a percentage of pre-tax income was 36.5% and 40% for the
three months ended September 30, 2004 and 2003, respectively. The effective tax
rate was higher than the U.S. statutory rate for the three months ended
September 30, 2004 and 2003 primarily due to state taxes and other
non-deductible items. The estimated effective tax rate for the three months
ended September 30, 2004 decreased from the prior year quarter due to certain
tax planning strategies implemented. The Company expects an effective tax rate
of approximately 37% for fiscal 2005. Tax benefits resulting from the exercise
of nonqualified stock options and the disqualifying dispositions of shares
issued under the Company's stock based compensation plans reduced taxes payable
by $129,000 and $1,515,000 for the quarter ended September 30, 2004 and 2003,
respectively. Such benefits are credited to capital in excess of par value.
The Company has open tax years in the U.S., Canada and other jurisdictions that
are currently not under examination by the applicable tax authorities and may be
subject to examination in the future. The Company periodically evaluates the
adequacy of its related tax reserves, taking into account its open tax return
positions and tax law changes. The Company believes that its tax reserves are
appropriate. However, the final determination of tax audits could impact the
Company's assessment of tax requirements.
7
MEMBERWORKS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE 11 - EARNINGS PER SHARE
Basic and diluted earnings per share amounts are determined in accordance with
the provisions SFAS 128. The following table sets forth the reconciliation of
the numerators and denominators in the computation of basic and diluted earnings
per share (in thousands, except per share data):
Three Months Ended
September 30,
----------------------
2004 2003
--------- ---------
Numerator:
Income available to common shareholders used in basic earnings per share $ 7,596 $ 3,895
Add Back: Interest expense on convertible securities 786 8
--------- ---------
Income available to common shareholders after assumed conversion of dilutive securities
and cumulative effect of accounting change for diluted earning per share $ 8,382 $ 3,903
========= =========
Denominator :
Weighted average number of common shares outstanding- basic 10,174 11,627
Effect of dilutive securities:
Convertible securities 545 25
Stock options 2,230 1,359
--------- ---------
Weighted average number of common shares outstanding- diluted 12,949 13,011
========= =========
Basic earnings per share $ 0.75 $ 0.33
========= =========
Diluted earnings per share $ 0.65 $ 0.30
========= =========
The diluted earnings per common share calculation excludes the effect of
potentially dilutive shares when their effect is antidilutive. Excluded from the
diluted share calculation above for the three months ended September 30, 2004
and 2003 are incremental weighted average stock option shares of approximately
1,169,000 and 0, respectively.
NOTE 12 - COMPREHENSIVE INCOME
The components of comprehensive income are as follows (in thousands):
Three Months Ended
September 30,
---------------------
2004 2003
-------- --------
Net income $ 7,596 $ 3,895
Unrealized gain on derivative assets 749 -
Foreign currency translation gain 98 2
-------- --------
Comprehensive income $ 8,443 $ 3,897
======== ========
NOTE 13 - BUSINESS SEGMENTS
The operating business segments reported below are the business segments of the
Company for which separate financial information is available and for which
operating results are evaluated regularly by executive management in deciding
how to allocate resources and in assessing performance. Prior to the acquisition
of Lavalife in April 2004, the Company operated as one reportable business
segment. Subsequent to the acquisition of Lavalife, the Company operates as two
reportable business segments: Membership and Personals. The Membership business
segment is primarily involved in the marketing of membership programs to
consumers. The Personals business segment is primarily involved in providing
both web-based and IVR-based personals services to its customers.
8
MEMBERWORKS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Management evaluates the operating results of each of its reportable business
segments based upon revenue and operating income. The following is a summary of
revenues, operating income, and assets by business segment (in thousands):
Three Months Ended
September 30,
-----------------------------
2004 2003
---------- ----------
Revenues:
Membership $ 117,278 $ 113,824
Personals 18,345 -
---------- ----------
Total $ 135,623 $ 113,824
========== ==========
Operating Income:
Membership $ 16,784 $ 6,620
Personals (52) -
---------- ----------
Total $ 16,732 $ 6,620
========== ==========
September 30, June 30,
2004 2004
---------- ----------
Assets:
Membership $ 178,576 $ 178,723
Personals 138,896 136,874
Corporate and other (1) 127,414 137,565
---------- ----------
Total $ 444,886 $ 453,162
========== ==========
(1) Represents unallocated non-operating assets including non-operating cash,
short-term investments, debt issuance costs and other.
NOTE 14 - GUARANTOR AND NONGUARANTOR FINANCIAL INFORMATION
In April 2004, the Company issued $150,000,000 aggregate principal amount of
9.25% Senior Notes in a private placement pursuant to Rule 144A. The Senior
Notes are unsecured obligations and will rank pari passu in right of payment to
all of the Company's existing and future senior unsecured indebtedness and
senior in right of payment to all of the Company's existing and future
subordinated indebtedness that expressly provides for its subordination to the
Notes. The Senior Notes are fully and unconditionally guaranteed by all of the
Company's existing and future domestic subsidiaries and certain of the Company's
existing and future foreign subsidiaries.
The following consolidating financial information presents the consolidating
balance sheets as of September 30, 2004 and June 30, 2004, the related
statements of operations for the three months ended September 30, 2004 and 2003
and the related statements of cash flows for the three months ended September
30, 2004 and 2003. The information includes the elimination entries necessary to
consolidate the Company ("Parent") with the guarantor and nonguarantor entities.
Investments in subsidiaries are accounted for by the Parent using the equity
method of accounting. The guarantor and nonguarantor subsidiaries are presented
on a combined basis. The principal elimination entries eliminate investments in
subsidiaries and intercompany balances and transactions.
9
MEMBERWORKS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
CONSOLIDATED BALANCE SHEETS
As of September 30, 2004
----------------------------------------------------------------------
Guarantor Nonguarantor Consolidated
Parent Subsidiaries Subsidiaries Eliminations Total
----------- ------------ ------------ ------------ -------------
Assets (in thousands)
Current assets $ 184,171 $ 48,337 $ 11,379 $ (8,189) $ 235,698
Fixed assets, net 18,300 13,650 2,107 - 34,057
Goodwill - 119,867 6,719 - 126,586
Intangible assets, net 1,408 36,273 - - 37,681
Other assets 10,821 43 - - 10,864
Intercompany notes receivable 2,052 - - (2,052) -
Investment in subsidiaries 172,174 - - (172,174) -
----------- ------------ ------------ ------------ -------------
Total assets $ 388,926 $ 218,170 $ 20,205 $ (182,415) $ 444,886
=========== ============ ============ ============ =============
Liabilities and Shareholders' (Deficit) Equity
Current liabilities $ 189,991 $ 43,361 $ 10,321 $ (8,189) $ 235,484
Deferred income taxes 1,424 9,243 (12) - 10,655
Other long-term liabilities 3,657 - 1,236 - 4,893
Intercompany notes payable - 2,052 - (2,052) -
Long-term debt 237,696 - - - 237,696
----------- ------------ ------------ ------------ -------------
Total liabilities 432,768 54,656 11,545 (10,241) 488,728
----------- ------------ ------------ ------------ -------------
Shareholders' (deficit) equity:
Preferred stock - - - - -
Common stock 191 6 3 (9) 191
Capital in excess of par value 157,505 165,070 9,564 (174,634) 157,505
Accumulated (deficit) earnings 17,727 (2,218) (608) 2,826 17,727
Accumulated other comprehensive loss 474 656 (299) (357) 474
Treasury stock (219,739) - - - (219,739)
----------- ------------ ------------ ------------ -------------
Total shareholders' (deficit) equity (43,842) 163,514 8,660 (172,174) (43,842)
----------- ------------ ------------ ------------ -------------
Total liabilities and shareholders' (deficit) equity $ 388,926 $ 218,170 $ 20,205 $ (182,415) $ 444,886
=========== ============ ============ ============ =============
10
MEMBERWORKS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
CONSOLIDATED BALANCE SHEETS
As of June 30, 2004
----------------------------------------------------------------------
Guarantor Nonguarantor Consolidated
Parent Subsidiaries Subsidiaries Eliminations Total
----------- ------------ ------------ ------------ -------------
Assets (in thousands)
Current assets $ 194,227 $ 42,955 $ 10,760 $ (6,572) $ 241,370
Fixed assets, net 19,675 14,823 2,042 - 36,540
Goodwill - 118,956 6,719 - 125,675
Intangible assets, net 1,050 37,822 - - 38,872
Other assets 10,666 39 - - 10,705
Intercompany notes receivable 95,543 - - (95,543) -
Investment in subsidiaries 78,633 - - (78,633) -
----------- ------------ ------------ ------------ -------------
Total assets $ 399,794 $ 214,595 $ 19,521 $ (180,748) $ 453,162
=========== ============ ============ ============ =============
Liabilities and Shareholders' (Deficit) Equity
Current liabilities $ 206,915 $ 40,549 $ 11,410 $ (6,572) $ 252,302
Deferred income taxes (2,402) 6,647 109 - 4,354
Other long-term liabilities 3,705 - 1,225 - 4,930
Intercompany notes payable - 95,543 - (95,543) -
Long-term debt 237,659 - - - 237,659
----------- ------------ ------------ ------------ -------------
Total liabilities 445,877 142,739 12,744 (102,115) 499,245
----------- ------------ ------------ ------------ -------------
Shareholders' (deficit) equity:
Preferred stock - - - - -
Common stock 191 6 3 (9) 191
Capital in excess of par value 156,457 71,744 9,564 (81,308) 156,457
Accumulated (deficit) earnings 10,131 (15) (2,305) 2,320 10,131
Accumulated other comprehensive loss (373) 121 (485) 364 (373)
Treasury stock (212,489) - - - (212,489)
----------- ------------ ------------ ------------ -------------
Total shareholders' (deficit) equity (46,083) 71,856 6,777 (78,633) (46,083)
----------- ------------ ------------ ------------ -------------
Total liabilities and shareholders' (deficit) equity $ 399,794 $ 214,595 $ 19,521 $ (180,748) $ 453,162
=========== ============ ============ ============ =============
11
MEMBERWORKS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
CONSOLIDATED STATEMENTS OF OPERATIONS
For Three Months Ended September 30, 2004
----------------------------------------------------------------------
Guarantor Nonguarantor Consolidated
Parent Subsidiaries Subsidiaries Eliminations Total
----------- ------------ ------------ ------------ -------------
(in thousands)
Revenues $ 96,285 $ 34,506 $ 5,320 $ (488) $ 135,623
Expenses:
Marketing 50,499 16,565 1,468 - 68,532
Operating 15,132 7,189 2,377 (488) 24,210
General and administrative 15,514 8,181 910 - 24,605
Amortization of intangible assets - 1,544 - - 1,544
----------- ------------ ------------ ------------ -------------
Operating income 15,140 1,027 565 - 16,732
Equity in income of subsidiary 820 - - (820) -
Interest (expense) income, net (4,700) 54 3 - (4,643)
Other income (expense), net (93) (64) 22 - (135)
----------- ------------ ------------ ------------ -------------
Income before income taxes 11,167 1,017 590 (820) 11,954
Provision for income taxes 3,571 521 266 - 4,358
----------- ------------ ------------ ------------ -------------
Net income $ 7,596 $ 496 $ 324 $ (820) $ 7,596
=========== ============ ============ ============ =============
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Three Months Ended September 30, 2003
----------------------------------------------------------------------
Guarantor Nonguarantor Consolidated
Parent Subsidiaries Subsidiaries Eliminations Total
----------- ------------ ------------ ------------ -------------
(in thousands)
Revenues $ 98,170 $ 12,870 $ 3,147 $ (363) $ 113,824
Expenses:
Marketing 59,111 6,507 1,038 - 66,656
Operating 17,382 3,202 1,242 (363) 21,463
General and administrative 15,385 2,506 876 - 18,767
Amortization of intangible assets - 318 - - 318
----------- ------------ ------------ ------------ -------------
Operating income 6,292 337 (9) - 6,620
Equity in income of subsidiaries 210 - - (210) -
Interest (expense) income, net (23) 28 28 - (33)
Other (expense) income, net (128) - (34) - (162)
----------- ------------ ------------ ------------ -------------
Income before income taxes 6,351 365 (15) (210) 6,491
Provision for income taxes 2,456 146 (6) - 2,596
----------- ------------ ------------ ------------ -------------
Net income $ 3,895 $ 219 $ (9) $ (210) $ 3,895
=========== ============ ============ ============ =============
12
MEMBERWORKS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Three Months Ended September 30, 2004
----------------------------------------------------------------------
Guarantor Nonguarantor Consolidated
Parent Subsidiaries Subsidiaries Eliminations Total
----------- ------------ ------------ ------------ -------------
(in thousands)
Net cash provided by (used in) operating activities $ 95,806 $ (86,872) $ (205) $ (820) $ 7,909
Investing activities
Acquisition of fixed assets (435) (161) (123) - (719)
Purchase of short-term investments (7,948) (245) - - (8,193)
Other investing activities (358) 662 - - 304
Investment in subsidiaries (94,146) 93,326 - 820 -
----------- ------------ ------------ ------------ -------------
Net cash (used in) provided by investing activities (102,887) 93,582 (123) 820 (8,608)
----------- ------------ ------------ ------------ -------------
Financing activities
Net proceeds from issuance of stock 919 - - - 919
Treasury stock purchases (7,250) - - - (7,250)
Net proceeds from issuance of debt (583) - - - (583)
Payments of long-term obligations (82) (8) - - (90)
----------- ------------ ------------ ------------ -------------
Net cash used in financing activities (6,996) (8) - - (7,004)
----------- ------------ ------------ ------------ -------------
Effect of exchange rate changes on cash and cash equivalents - (88) 260 - 172
----------- ------------ ------------ ------------ -------------
Net increase (decrease) in cash and cash equivalents (14,077) 6,614 (68) - (7,531)
Cash and cash equivalents at beginning of period 130,581 26,657 2,258 - 159,496
----------- ------------ ------------ ------------ -------------
Cash and cash equivalents at end of period $ 116,504 $ 33,271 $ 2,190 $ - $ 151,965
=========== ============ ============ ============ =============
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Three Months Ended September 30, 2003
----------------------------------------------------------------------
Guarantor Nonguarantor Consolidated
Parent Subsidiaries Subsidiaries Eliminations Total
----------- ------------ ------------ ------------ -------------
(in thousands)
Net cash provided by (used in) operating activities $ (1,902) $ 520 $ (426) $ (210) $ (2,018)
Investing activities
Acquisition of fixed assets (775) (105) (41) - (921)
Investment in subsidiaries (210) - - 210 -
----------- ------------ ------------ ------------ -------------
Net cash provided by (used in) investing activities (985) (105) (41) 210 (921)
----------- ------------ ------------ ------------ -------------
Financing activities
Net proceeds from issuance of stock 22,089 - - - 22,089
Treasury stock purchases (56,352) - - - (56,352)
Net proceeds from the issuance of debt 87,019 - - - 87,019
Payments of long-term obligations - (67) - - (67)
----------- ------------ ------------ ------------ -------------
Net cash provided by (used in) financing activities 52,756 (67) - - 52,689
----------- ------------ ------------ ------------ -------------
Effect of exchange rate changes on cash and cash equivalents - - 2 - 2
----------- ------------ ------------ ------------ -------------
Net increase (decrease) in cash and cash equivalents 49,869 348 (465) - 49,752
Cash and cash equivalents at beginning of period 51,895 18,716 1,649 - 72,260
----------- ------------ ------------ ------------ -------------
Cash and cash equivalents at end of period $ 101,764 $ 19,064 $ 1,184 $ - $ 122,012
=========== ============ ============ ============ =============
13
MEMBERWORKS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE 15 - SUBSEQUENT EVENTS
On October 20, 2004, the Company announced that it had entered into an agreement
to acquire Bargain Network Inc. a privately held provider of premier pricing
services for homes, vehicles and consumer durables. The Company has agreed to
pay $27,000,000 in cash at closing in addition to assuming certain liabilities.
In addition, the Company will pay additional amounts in 2005 if certain
milestones are achieved.
On November 8, 2004, the Company announced its intention to initiate a Dutch
auction tender offer for up to 500,000 shares of its common stock, which
represents approximately 5 percent of its outstanding shares. Under this
procedure, the Company's stockholders will be given the opportunity to sell part
or all of their shares to the Company at a price of not less than $30.00 per
share and not more than $35.00 per share. This price range represents a 5.9%
discount to a 9.8% premium when compared to the November 5, 2004 closing price
of $31.874 per share. Based upon the minimum and maximum offering prices
specified in the offer, the aggregate purchase price, if 500,000 shares are
purchased, would range from $15,000,000 to $17,500,000.
14
MEMBERWORKS INCORPORATED
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
On October 13, 2004, MemberWorks Incorporated (the "Company") began doing
business as Vertrue Incorporated. The name change was intended to reflect the
ever-broadening base of membership services that the Company offers to its
customers. The Company is a category leader in both membership and loyalty
programs. The Company's membership programs are both subscription and
transaction based offerings focused on meeting consumer needs in large spending
categories - healthcare, discounts, security and personals. Our programs offer
everyday savings, event-oriented discounts, peace of mind and unique consumer
benefits. Programs are available in English, French and Spanish and are
increasingly customized for specific client customer segments or consumer
communities. The Company's loyalty programs provide clients with a wide range of
benefits to offer or market to their customers and include stand-alone benefits,
reward point accumulation and management, gift certificate, merchandise and
travel reward redemption. The Company's versatility in designing loyalty
strategies and providing turnkey execution is essential in supporting and
promoting the client's brand.
The Company operates in two business segments: Membership and Personals. For
additional financial information about these business segments, see Note 13 to
the condensed consolidated financial statements.
Membership service programs offer consumers a variety of products and services
from selected vendors for an annual or monthly fee. Revenues are derived
principally from recurring fees which are billed to the member either on an
annual or monthly basis. In the case of annually billed membership fees, the
Company receives full payment at or near the beginning of the membership period,
but recognizes the revenues as the member's refund privilege expires. Membership
fees that are billed monthly are recognized when earned. Profitability and cash
flow generated from renewal memberships exceed that of new memberships due to
the absence of solicitation costs associated with new member procurement.
The personals business segment employs a transactional business model, in which
users buy non-refundable credits up front and spend those credits only when they
want to interact with other users. Personals revenues are generally recognized
when the services are used.
CRITICAL ACCOUNTING POLICIES
Critical accounting policies are those policies that are important to the
Company's financial condition and results of operations and involve subjective
or complex judgments on the part of management, often as a result of the need to
make estimates. The following areas require the use of judgments and estimates:
membership cancellation rates, deferred marketing costs, valuation of goodwill
and other intangible assets, estimation of remaining useful lives of intangible
assets and valuation of deferred tax assets. Estimates in each of these areas
are based on historical experience and various assumptions that the Company
believes are appropriate. Actual results may differ from these estimates. The
Company believes the areas listed above represent the critical accounting
policies of the Company as contemplated by Financial Reporting Release No. 60,
"Cautionary Advice Regarding Disclosure about Critical Accounting Policies." The
Company's critical accounting policies are disclosed in Item 7, Management's
Discussion and Analysis of Financial Condition and Results of Operations in the
Company's Annual Report on Form 10-K for the year ended June 30, 2004. Since the
date of the Annual Report on Form 10-K, there have been no material changes to
the Company's critical accounting policies. For a summary of all of the
Company's significant accounting policies, see Note 2 to the consolidated
financial statements located in the Company's 2004 Annual Report on Form 10-K.
15
MEMBERWORKS INCORPORATED
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
For the Three Months Ended September 30, 2004
Three Months Ended Percent
September 30, Increase
------------------------- -----------
Revenues: 2004 2003 '04 vs.'03
---- ---- -----------
Membership $ 117,278 $ 113,824 3%
Personals 18,345 - NM
---------- ---------- -----------
Total $ 135,623 $ 113,824 19%
========== ========== ===========
NM = Not Meaningful
Membership
Revenues increased 3% in 2004 primarily due to expanded product marketing with
certain existing retail and loyalty clients. The net active retail members
decreased 13% to 5.5 million as of September 30, 2004 primarily due to the
decrease in members enrolled through the outbound telemarketing channel which
was not completely offset by an increase in members enrolled through the
Company's online and MemberLink channels. The decline in net active retail
members may impact future revenues and profitability. The mix of new members
enrolled in a monthly payment plan program was 83% and 63% in 2004 and 2003,
respectively.
Revenues from members enrolled in different payment programs are summarized
below:
Percent
Three Months Ended Increase/
September 30, 2004 (Decrease)
------------------------- -----------
Revenues: 2004 2003 '04 vs.'03
---- ---- -----------
Monthly payment plans $ 49,457 $ 26,348 88%
Annual payment plans:
Initial year 19,050 41,055 (54)%
Renewal year 48,771 46,421 5%
---------- ---------- -----------
Total $ 117,278 $ 113,824 3%
========== ========== ===========
Personals
Revenues were $18.3 million and represent the revenues of Lavalife, which was
acquired by the Company on April 1, 2004. There were approximately 600,000
active customers as of September 30, 2004.
Three Months Ended Percent
September 30, Increase
------------------------- -----------
Operating income: 2004 2003 '04 vs. '03
---- ---- -----------
Membership $ 16,784 $ 6,620 154%
Personals (52) - NM
---------- ---------- -----------
Total $ 16,732 $ 6,620 153%
========== ========== ===========
NM = Not Meaningful
Membership
Operating income increased 154% primarily due to a decrease in marketing
expenses incurred of 9% while revenues increased 3%. Marketing expenses were
$60.9 million in 2004 versus $66.7 million in 2003 and, as a percentage of
revenues, marketing expenses were 52% in 2004 versus 59% in 2003. These
decreases were primarily due to the maturing of the monthly membership base.
Operating income further benefited from a decrease in operating expenses.
Operating expenses decreased 4% in 2004 and, as a percent of revenues were 18%
in 2004 and 19% in 2003, primarily driven by the decreased costs incurred to
service the lower membership base.
16
MEMBERWORKS INCORPORATED
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Personals
Operating loss was $52,000 in 2004 and represented the results of Lavalife.
Operating loss reported for 2004 reflected $1.3 million of expense for the
amortization of intangible assets.
Three Months Ended Percent
September 30, Increase
------------------------- -----------
Corporate: 2004 2003 '04 vs.'03
---- ---- -----------
Interest (expense) income, net $ (4,643) $ 33 NM
Other expense, net (135) (162) 17%
Provision for income taxes 4,358 2,596 68%
NM = Not Meaningful
Interest expense, net. The increase in interest expense, net in 2004 was due to
interest expense related to the 5.5% Convertible Senior Subordinated Notes
issued in September 2003 and interest expense related to the 9.25% Senior Notes
issued in April 2004. For additional information on these debt issuances, refer
to the related discussion located in the Liquidity and Capital Resources section
of this Quarterly Report on Form 10-Q.
Provision for income taxes. The Company recorded a provision for income taxes of
$4.4 million and $2.6 million based on an effective tax rate of 36.5% and 40% in
2004 and 2003, respectively. The effective tax rate was higher than the U.S.
federal statutory rate due to state tax expense and other non-deductible items.
The estimated effective tax rate in 2004 decreased from the prior year due to
certain tax planning strategies implemented. The Company expects an effective
tax rate of approximately 37% for fiscal 2005.
LIQUIDITY AND CAPITAL RESOURCES
Net cash flow provided by operating activities is an important measure used to
understand the Company's liquidity. Management believes it is useful to analyze
the components of net cash provided by operating activities as follows: Revenue
before deferral, marketing costs before deferral, operating expenses, general
and administrative expenses and changes in assets and liabilities. For
definitions and reconciliations of revenue before deferral and marketing costs
before deferral see "Reconciliation of Non-GAAP Measures" located elsewhere in
this Quarterly Report on Form 10-Q.
Net cash provided by operating activities was $7.9 million for the quarter ended
September 30, 2004 and cash used by operating activities was $2.0 million for
the quarter ended September 30, 2003.
Revenues before deferral increased 19% to $119.3 million for the quarter ended
September 30, 2004 from $100.2 million for the quarter ended September 30, 2003
primarily due to revenues before deferral generated by Lavalife. The new annual
weighted average program price point per retail member was flat compared to the
prior year period at $105 for the quarter ended September 30, 2004. Monthly
weighted average program price points per retail member were $11.83 and $10.72
for the quarter ended September 30, 2004 and 2003, respectively.
The table below summarizes the components of revenues before deferral for the
three months ended September 30:
2004 2003
---------- ----------
Monthly payment plans $ 50,295 $ 31,823
Annual payment plans:
Initial year 9,627 21,000
Renewal year 40,768 47,339
Personals 18,598 -
---------- ----------
Total $ 119,288 $ 100,162
========== ==========
Marketing costs before deferral were $62.2 million and $57.4 million for the
quarter ended September 30, 2004 and 2003, respectively. For the quarter ended
September 30, 2004, marketing costs before deferral increased 8% primarily due
to marketing costs incurred by Lavalife offset by a decrease in the level of
marketing through the outbound telemarketing channel. As a percent of revenue
before deferral, marketing costs before deferral were 52% for the quarter ended
September 30, 2004 versus 57% for the quarter ended September 30, 2003 due to
the effect of the maturing base of members enrolled in a monthly payment plan
program and the reduced level and mix of the higher cost outbound telemarketing.
17
MEMBERWORKS INCORPORATED
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Net cash provided by operating activities for the quarter ended September 30,
2004 was negatively impacted by increased general and administrative and
operating expenses. The increase in these expenses was primarily due to the
acquisition of Lavalife. Net cash provided by operating activities was also
impacted by changes in assets and liabilities, which provided $1.2 million of
cash for the quarter ended September 30, 2004 and used $7.3 million of cash for
the quarter ended September 30, 2003. The primary driver of the increase in cash
provided by changes in assets and liabilities for the quarter ended September
30, 2004 was the increase in accrued interest related to the Company's
outstanding debt offset by a decrease in the allowance for membership
cancellations which reflects the decrease in the programs marketed with an
annual payment program.
Net cash used in investing activities was $8.6 million for the quarter ended
September 30, 2004 compared to $0.9 million for the quarter ended September 30,
2003. For the quarter ended September 30, 2004, the Company purchased $8.2
million of short-term investments. Capital expenditures were $0.7 million and
$0.9 million for the quarter ended September 30, 2004 and 2003, respectively.
Net cash used in financing activities was $7.0 million for the quarter ended
September 30, 2004 compared to net cash provided by financing activities of
$52.7 million for the quarter ended September 30, 2003. Net cash used in
financing activities for the quarter ended September 30, 2004 principally
reflected the use of $7.3 million in cash to repurchase the Company's stock
offset by proceeds from the exercise of employee stock options of $0.9 million.
Net cash provided by financing activities for the quarter ended September 30,
2003 principally reflected the issuance of $87.0 million in debt, net of
issuance costs, and proceeds from the exercise of employee stock options of
$22.1 million. These sources of cash were partially offset by the use of $56.4
million in cash to repurchase the Company's stock.
Debt Issuances
As of September 30, 2004, the Company has $237.7 million of debt outstanding. In
September 2003, the Company issued $90.0 million aggregate principal amount 5.5%
convertible senior subordinated notes ("Convertible Notes") due September 2010.
The Convertible Notes bear interest at the rate of 5.5% per year, which is
payable in cash semi-annually in arrears on April 1 and October 1 of each year.
Upon the occurrence of a change in control, holders of the Convertible Notes may
require the Company to repurchase all or part of the Convertible Notes for cash.
In April 2004, the Company issued $150.0 million aggregate principal amount of
9.25% Senior Notes due 2014 ("Senior Notes"). The Senior Notes were sold at
98.418% of the principal amount which results in an effective yield of 9.5%.
Interest is payable in cash semi-annually in arrears on April 1 and October 1 of
each year. A portion of the proceeds from the offering of the Senior Notes was
used to repay amounts borrowed under the senior secured credit facility to fund
a portion of the Lavalife acquisition. The Company intends to use the remaining
proceeds for general corporate purposes, including working capital, future
acquisitions and repurchases of the Company's common stock under the Company's
stock buyback program to the extent permitted under the indenture governing the
Senior Notes and the senior secured credit facility. The Senior Notes offering
was made solely by means of a private placement to qualified institutional
buyers pursuant to Rule 144A under the Securities Act of 1933, as amended, and
to certain persons in offshore transactions pursuant to Regulation S under the
Securities Act. The Senior Notes have not been registered under the Securities
Act and may not be offered or sold in the United States, or to a U.S. person,
absent registration or an applicable exemption from registration requirements.
On November 5, 2004, the Company filed a registration statement on Form S-4 with
the Securities and Exchange Commission ("SEC") related to the Senior Notes. The
Company intends to use its best efforts to cause the registration statement to
be declared effective by the SEC no later than 210 days after the original
issuance of the Senior Notes.
Credit Facility
The Company has an amended and restated senior secured credit facility that
allows borrowings of up to $45.0 million. Borrowings under the senior secured
credit facility accrue interest at either the Eurodollar rate, or the higher of
the Prime rate or the Federal Funds rate, plus an applicable margin. As of
September 30, 2004, the availability under the senior secured credit facility
was reduced by an outstanding letter of credit of $5.5 million and one year's
worth of interest on the Senior Notes. As of September 30, 2004, the
availability under the senior secured credit facility is approximately $25.7
million. As of September 30, 2004, the effective interest rate for borrowings
under the senior secured credit facility was 4.75%. The senior secured credit
facility has certain financial covenants, including a maximum debt coverage
ratio, potential restrictions on additional borrowings and potential
restrictions on additional stock repurchases. As of September 30, 2004, the
Company was in compliance with all such debt covenants.
18
MEMBERWORKS INCORPORATED
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Stock Repurchase Program
The Company purchased 0.3 million shares for $7.3 million at an average price of
$26.03 for the quarter ended September 30, 2004 compared to 1.7 million shares
for $56.4 million at an average price of $33.24 for the quarter ended September
30, 2003. The Company utilized existing cash balances to repurchase shares for
the quarter ended September 30, 2004. In October 2004, the Company's Board of
Directors authorized the repurchase of an additional one million shares of its
common stock under its ongoing stock repurchase program. Subsequent to this
additional authorization, the Company has 1.7 million shares available for
repurchase under its stock repurchase program.
On November 8, 2004, the Company announced its intention to initiate a Dutch
auction tender offer for up to 500,000 shares of its common stock, which
represents approximately 5 percent of its outstanding shares. Under this
procedure, the Company's stockholders will be given the opportunity to sell part
or all of their shares to the Company at a price of not less than $30.00 per
share and not more than $35.00 per share. This price range represents a 5.9%
discount to a 9.8% premium when compared to the November 5, 2004 closing price
of $31.874 per share. Based upon the minimum and maximum offering prices
specified in the offer, the aggregate purchase price, if 500,000 shares are
purchased, would range from $15.0 million to $17.5 million.
On October 20, 2004, the Company announced that it had entered into an agreement
to acquire Bargain Network Inc., a privately held provider of premier pricing
services for homes, vehicles and consumer durables. The Company has agreed to
pay $27 million in cash at closing in addition to assuming certain liabilities.
In addition, the Company will pay additional amounts in 2005 if certain
milestones are achieved.
As of September 30, 2004, the Company had cash and cash equivalents of $152.0
million in addition to its senior secured credit facility. The Company believes
that existing cash and short term investment balances, together with funds
available under its senior secured credit facility, will be sufficient to meet
its funding requirements for the foreseeable future.
The Company did not have any material commitments for capital expenditures as of
September 30, 2004. The Company intends to utilize cash on hand and cash
generated from operations to fulfill any capital expenditure requirements during
2005.
RECONCILIATION OF NON-GAAP MEASURES
Management believes that revenues before deferral and marketing costs before
deferral are important measures of liquidity and are significant factors in
understanding the Company's operating cash flow trends. These non-GAAP measures
are used by management and the Company's investors to understand the liquidity
trends of the Company's marketing margins related to the current period
operations which are reflected within the operating cash flow section of the
cash flow statement. GAAP revenues and marketing expenses are important measures
used to understand the marketing margins earned during the period in the income
statement. However, in order to understand the Company's operating cash flow, it
is important to understand the primary, current period drivers of that cash
flow. Two of the primary indicators of operating liquidity for the period are
revenues before deferral and marketing costs before deferral. Revenues before
deferral are revenues before the application of SAB 104 and represent the
revenues billed during the current reporting period less an allowance for
membership cancellations. That is, revenues before deferral for a reporting
period include membership fees received in the current reporting period that
will be recorded as GAAP revenues in future reporting periods and exclude
membership fees received in prior reporting periods that are recorded as GAAP
revenues in the current reporting period. Marketing costs before deferral are
marketing costs before the application of SAB 104 and SOP 93-7 and represent
marketing costs paid for or accrued for during the current reporting period.
That is, marketing costs before deferral for a reporting period include costs
paid or accrued in the current reporting period that will be recorded as GAAP
marketing expenses in future reporting periods and exclude marketing expenses
paid or accrued in prior reporting periods that are recorded as GAAP marketing
expenses in the current reporting period. Neither revenues before deferral nor
marketing costs before deferral exclude charges or liabilities that will require
cash settlement. Additionally, these measures are not a substitute for, or
superior to, Revenues and Marketing Expenses prepared in accordance with
generally accepted accounting principles. In light of the difference between
revenues before deferral, marketing expenses before deferral and their most
directly comparable GAAP measures, the Company solely uses these measures as
liquidity measures and not as performance measures.
19
MEMBERWORKS INCORPORATED
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Revenues before deferral for the three months ended September 30, 2004 and 2003
are calculated as follows:
2004 2003
---------- ----------
Revenues $ 135,623 $ 113,824
Change in deferred revenues (16,335) (13,662)
---------- ----------
Revenues before deferral $ 119,288 $ 100,162
========== ==========
Marketing cost before deferral for the three months ended September 30, 2004 and
2003 is calculated as follows:
2004 2003
---------- ----------
Marketing expenses $ 68,532 $ 66,656
Change in membership solicitation and other deferred costs (6,348) (9,221)
---------- ----------
Marketing costs before deferral $ 62,184 $ 57,435
========== ==========
FORWARD LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains forward-looking statements that are
based on current expectations, estimates, forecasts and projections about the
industry in which the Company operates and the Company's management's beliefs
and assumptions. These forward-looking statements include statements that do not
relate solely to historical or current facts and can be identified by the use of
words such as "believe," "expect," "estimate," "project," "continue" or
"anticipate." These forward-looking statements are made pursuant to safe harbor
provisions of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements are not guarantees of future performance and are
based on a number of assumptions and estimates that are inherently subject to
significant risks and uncertainties, many of which are beyond our control,
cannot be foreseen and reflect future business decisions that are subject to
change. Therefore, actual outcomes and results may differ materially from what
is expressed or forecasted in such forward-looking statements. Among the many
factors that could cause actual results to differ materially from the
forward-looking statements are:
o higher than expected membership cancellations or lower than expected
membership renewal rates;
o changes in the marketing techniques of credit card issuers;
o increases in the level of commission rates and other compensation required
by marketing partners to actively market with the Company;
o potential reserve requirements by business partners such as the Company's
credit card processors;
o unanticipated termination of marketing agreements;
o the extent to which the Company can continue to successfully develop and
market new products and services and introduce them in a timely basis;
o the Company's ability to integrate acquired businesses into the Company's
management and operations and operate successfully;
o unanticipated changes in or termination of the Company's ability to process
revenues through third parties, including credit card processors and bank
card associations;
o the Company's ability to develop and implement operational and financial
systems to manage growing operations;
o the Company's ability to recover from a complete or partial system failure
or impairment, other hardware or software related malfunctions or
programming errors;
o the degree to which the Company is leveraged;
o the Company's ability to obtain financing on acceptable terms to finance
the Company's growth strategy and to operate within the limitations imposed
by financing arrangements;
o further changes in the already competitive environment for the Company's
products or competitors' responses to the Company's strategies;
o changes in the growth rate of the overall U.S. economy, or the
international economy where the Company does business, such that credit
availability, interest rates, consumer spending and related consumer debt
are impacted;
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MEMBERWORKS INCORPORATED
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
o additional government regulations and changes to existing government
regulations of the Company's industry;
o the Company's ability to compete with other companies that have financial
or other advantages;
o adverse movement of foreign exchange rates;
o the Company's ability to attract and retain active members and users;
o adverse results of litigation or regulatory matters; and
o new accounting pronouncements.
Many of these factors are beyond the Company's control, and, therefore, its
business, financial condition, results of operations and cash flows may be
adversely affected by these factors.
The Company cautions that such factors are not exclusive. All of the
forward-looking statements made in this Quarterly Report on Form 10-Q are
qualified by these cautionary statements and readers are cautioned not to place
undue reliance on these forward-looking statements, which speak only as of the
date of this Quarterly Report on Form 10-Q. Except as required by law, the
Company does not have any intention or obligation to publicly update any
forward-looking statements, whether as a result of new information, future
events or otherwise.
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MEMBERWORKS INCORPORATED
Item 3. Quantitative and Qualitative Disclosures about Market Risk
----------------------------------------------------------
Interest Rate
The Company has a senior secured credit facility that allows borrowings of up to
$45.0 million. Borrowings under the senior secured credit facility accrue
interest at either the Eurodollar rate or the higher of the Prime rate or the
Federal Funds rate plus an applicable margin. There were no borrowings
outstanding under this senior secured credit facility as of September 30, 2004.
As of September 30, 2004, availability under the senior secured credit facility
was reduced by an outstanding letter of credit of $5.5 million and one year's
worth of interest on the Senior Notes. As of September 30, 2004, the
availability under the senior secured credit facility is approximately $25.7
million. Management believes that an increase in the Eurodollar rate, the Prime
rate or the Federal Funds rate would not be material to the Company's financial
position or its results of operations. If the Company is not able to renew its
existing credit facility agreement, which matures on March 25, 2005, it is
possible that any replacement lending facility obtained by the Company may be
more sensitive to interest rate changes. In addition, the Company has $90.0
million aggregate principal amount of 5.5% Convertible Notes due 2010 and $150.0
million aggregate principal amount of 9.25% Senior Notes due 2014. The
Convertible Notes and the Senior Notes pay interest in cash semi-annually in
arrears on April 1 and October 1 of each year. The fair value of the fixed
interest instruments are affected by changes in interest rates, and with respect
to the Convertible Notes, are also affected by changes in the Company's stock
price and volatility. The Company does not currently hedge interest rates with
respect to its outstanding debt. As of September 30, 2004, the carrying value of
the Convertible Notes and the Senior Notes was $90.0 million and $147.7 million,
respectively, and the fair value of the notes were $85.5 million and $150.0
million, respectively.
Foreign Currency
The Company conducts business in certain foreign markets, primarily in Canada.
The Company's primary exposure to foreign currency risk relates to investments
in foreign subsidiaries that transact business in functional currencies other
than the U.S. Dollar, primarily the Canadian Dollar. As the Company increases
its operations in international markets, it becomes increasingly exposed to
potentially volatile movements in currency exchange rates. The economic impact
of currency exchange rate movements on the Company are often linked to
variability in real growth, inflation, interest rates, governmental actions and
other factors. These changes, if material, could cause the Company to adjust its
financing and operating strategies. As currency exchange rates change,
translation of the income statements of the Company's international business
into U.S. dollars affects year-over-year comparability of operating results.
The Company uses purchase option contracts and forward contacts to minimize its
exposure to changes in future cash flows caused by movements in foreign currency
exchange rates between the US dollar and the Canadian dollar. However, there can
be no assurance that the Company's foreign currency hedging activities will
substantially offset the impact of fluctuations in currency exchange rates on
its results of operations and financial position. The Company does not use
derivatives for speculative purposes. Derivatives used to hedge forecasted
transactions and specific cash flows associated with Canadian dollar denominated
financial assets and liabilities that meet the criteria for hedge accounting are
designated as cash flow hedges. The effective portion of gains and losses is
deferred as a component of accumulated other comprehensive income and is
recognized in earnings in the same line item as the underlying hedged item at
the time the hedged item affects earnings.
Fair Value of Investments
The Company does not have material exposure to market risk with respect to
investments, as the Company's investments are short-term in nature (original
maturities of less than one year).
Item 4. Controls and Procedures
-----------------------
Evaluation of disclosure controls and procedures.
The Chief Executive Officer and Chief Financial Officer have evaluated the
effectiveness of the Company's disclosure controls and procedures (as defined
under Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this
report and have concluded that the Company's disclosure controls and procedures
were effective at the reasonable assurance level. The Company's disclosure
controls and procedures are designed to ensure that material information
relating to the Company and its consolidated subsidiaries that is required to be
disclosed in its reports under the Exchange Act is accumulated and communicated
to the Chief Executive Officer and Chief Financial Officer.
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MEMBERWORKS INCORPORATED
Notwithstanding the foregoing, although there can be no assurance that the
Company's disclosure controls and procedures will detect or uncover all failures
of persons within the Company and its consolidated subsidiaries to disclose
material information otherwise required to be set forth in the Company's
periodic reports, the Chief Executive Officer's and Chief Financial Officer's
evaluation concluded that they are reasonably effective to do so.
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MEMBERWORKS INCORPORATED
PART II. OTHER INFORMATION
Item 1. Legal proceedings
-----------------
Except as set forth below, in management's opinion, there are no significant
legal proceedings to which the Company or any of its subsidiaries is a party or
to which any of their properties are subject. The Company is involved in other
lawsuits and claims generally incidental to its business including, but not
limited to, various suits, including previously disclosed suits, brought against
the Company by individual consumers seeking monetary and/or injunctive relief
relating to the marketing of the Company's programs. In addition, from time to
time, and in the regular course of its business, the Company receives inquiries
from various federal and/or state regulatory authorities.
On October 21, 2003, the Florida Attorney General's Office filed a civil
complaint against the Company based upon concerns that some of its past
marketing practices may have violated various consumer laws. On June 28, 2004,
the Company announced that it had reached a voluntary settlement with the
Florida Attorney General's office to alleviate these concerns. In connection
with the settlement, the Company agreed to formalize its existing national Best
Marketing Practices in the state of Florida and to pay the state of Florida
costs of investigation of $950,000. The Company expects that the agreement will
have little new effect on its business in Florida as the agreement serves to
formalize the Company's already existing national marketing best practices in
the state.
On January 24, 2003, the Company filed a motion with the Superior Court for the
Judicial District of Hartford, Connecticut to vacate and oppose the confirmation
of an arbitration award issued in December 2002. The arbitration, filed against
the Company by MedValUSA Health Programs, Inc. ("MedVal") in September 2000,
involved claims of breach of contract, breach of the duty of good faith and fair
dealing, and violation of the Connecticut Unfair Trade Practices Act ("CUTPA").
Even though the arbitrators found that the Company was not liable to MedVal for
any compensatory damages, they awarded $5.5 million in punitive damages and
costs against the Company solely under CUTPA. The Company believes that this
arbitration award is unjustified and not based on any existing legal precedent.
Specifically, the Company is challenging the award on a number of grounds,
including that it violates a well defined public policy against excessive
punitive damage awards, raises constitutional issues and disregards certain
legal requirements for a valid award under CUTPA. The hearing on the Company's
motion was held on February 10, 2003. On June 22, 2003, the Superior Court
denied the Company's motion to vacate the award, and the Company filed an appeal
of that decision. While the Company intends to take action to prevent the
enforcement of the award by, among other things, vigorously pursuing an appeal,
there can be no assurance that the Company will be successful in its efforts.
The Company has made no provision in its financial statements for this
contingency because it believes that a loss is not probable. If the Company was
ultimately unsuccessful in this or other available appeals, and a final
non-appealable court order confirming the arbitration award is rendered, the
payment of the award could have a material adverse effect on the Company's
results of operations in the period in which the final order is entered.
In March 2001, an action was instituted by plaintiff Teresa McClain against
Coverdell & Company ("Coverdell"), a wholly-owned subsidiary of the Company,
Monumental Life Insurance Company and other defendants in the United States
District Court for the Eastern District of Michigan, Southern Division. The
suit, which seeks unspecified monetary damages, alleges that Coverdell and the
other defendants violated the Michigan Consumer Protection Act and other
applicable Michigan laws in connection with the marketing of Monumental Life
Insurance Company insurance products. The Court certified a class of Michigan
residents. The Court has now signed an Order granting preliminary approval of a
settlement agreement that has been signed by all parties. The Court will hold
the Fairness/Approval hearing on November 22, 2004. The settlement agreement
will have no financial or other material impact on the Company's business.
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MEMBERWORKS INCORPORATED
PART II. OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds and Issuer Purchases of Equity
------------------------------------------------------------------------
Securities
----------
The following table summarizes the shares of the Company's equity securities
purchased by or on behalf of the Company:
Maximum
Total Number of Number of Shares
Total Shares Purchased that May Yet be
Number of as Part of Publicly Purchased Under
Shares Average Price Announced Plans the Plans or
Period Purchased Paid per Share or Programs (1) Programs
- --------------------------------------- ------------ -------------- ------------------- ----------------
July 1, 2004 to July 31, 2004 - $ - - 993,507
August 1, 2004 to August 31, 2004 110,000 $ 25.00 110,000 883,507
September 1, 2004 to September 30, 2004 168,500 $ 26.70 168,500 715,007
------------ -------------- ------------------- ----------------
Total 278,500 $ 26.03 278,500 715,007
============ ============== =================== ================
(1) During 2004, the Board of Directors authorized the following share amounts
to be purchased under the Company's stock buyback program originally
authorized during fiscal 1997:
January 2004 - authorized an additional 1,000,000 shares, no expiration.
October 2004 - authorized an additional 1,000,000 shares, no expiration.
Item 6. Exhibits
--------
Exhibits
31.1 Rule 13a-14(a) CEO Certification.
31.2 Rule 13a-14(a) CFO Certification.
32.1 CEO Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 CFO Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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MEMBERWORKS INCORPORATED
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.
MEMBERWORKS INCORPORATED
(Registrant)
Date: November 9, 2004 By: /s/ Gary A. Johnson
-------------------
Gary A. Johnson, President, Chief
Executive Officer and Director
November 9, 2004 By: /s/ James B. Duffy
------------------
James B. Duffy, Executive Vice President and
Chief Financial Officer (Principal Financial
and Accounting Officer)
26