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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: December 27, 2003 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 Identification No.)
incorporation or organization)
1260 16th Avenue West, Seattle, WA 98119
- ---------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (206) 281-1390
--------------
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 January 30, 2004, there were issued and outstanding 16,690,706 shares of
common stock, par value $.01 per share.
Index to Exhibits at Page 16
Page 1 of 19
PHOTOWORKS, INC.
INDEX
Page No.
--------
PART I -- FINANCIAL INFORMATION
Item 1 - Financial Statements 3-10
Consolidated Balance Sheets as of December 27, 2003
and September 27, 2003 3
Consolidated Statements of Operations for the first quarter
ended December 27, 2003 and December 28, 2002 4
Consolidated Statements of Cash Flows for the first quarter
ended December 27, 2003 and December 28, 2002 5
Notes to Consolidated Financial Statements 6-10
Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations 10-13
PART II -- OTHER INFORMATION
Item 1 - Legal Proceedings 14
Item 5 - Controls and Procedures 14
Item 6 - Exhibits and Reports on Form 8-K 14
SIGNATURES 15
INDEX TO EXHIBITS 16
CERTIFICATIONS 17-19
Page 2 of 19
PART I -- FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
PHOTOWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
(UNAUDITED) (NOTE)
December 27, September 27,
ASSETS 2003 2003
=============================
CURRENT ASSETS
Cash and cash equivalents $ 3,751 $ 4,756
Accounts receivable, net of allowance for doubtful accounts 58 28
Inventories 751 652
Prepaid expenses 290 354
-------- --------
TOTAL CURRENT ASSETS 4,850 5,790
Furniture, fixtures, and equipment at cost, less accumulated depreciation 1,781 1,821
Lease deposits 51 51
-------- --------
TOTAL ASSETS $ 6,682 $ 7,662
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable $ 1,321 $ 1,376
Accrued compensation 893 1,260
Other accrued expenses 556 588
ITC penalty, current portion 243 239
Current portion of capital lease obligations 2 2
Income taxes payable -- 14
Deferred revenues 387 477
-------- --------
TOTAL CURRENT LIABILITIES 3,402 3,956
Subordinated convertible debentures 2,500 2,500
ITC penalty, non-current portion 646 636
Capital lease obligations, net of current portion 6 6
-------- --------
TOTAL LIABILITIES 6,554 7,098
SHAREHOLDERS' EQUITY
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 16,685,285 167 167
Additional paid-in capital 15,834 15,803
Accumulated deficit (15,873) (15,406)
-------- --------
TOTAL SHAREHOLDERS' EQUITY 128 564
-------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 6,682 $ 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.
Page 3 of 19
PHOTOWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(in thousands, except per share and share data)
First Quarter Ended
---------------------------------
December 27, December 28,
2003 2002
======================================================================================
Net revenues $ 5,755 $ 8,353
Cost of goods and services 4,053 6,478
------------ ------------
GROSS PROFIT 1,702 1,875
Operating expenses:
Marketing 577 919
Research and development 465 536
General and administrative 1,093 1,435
------------ ------------
Total operating expenses 2,135 2,890
------------ ------------
LOSS FROM OPERATIONS (433) (1,015)
Other income (expense):
Interest expense (58) (42)
Other income (expense), net 24 7
------------ ------------
Total other expense (34) (35)
------------ ------------
NET LOSS $ (467) $ (1,050)
============ ============
Loss per share $ (.03) $ (.06)
============ ============
Weighted average number of shares outstanding 16,667,000 16,655,000
============ ============
See accompanying notes to consolidated financial statements.
Page 4 of 19
PHOTOWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(in thousands)
First Quarter Ended
----------------------------
December 27, December 28,
2003 2002
==================================================================================================================
OPERATING ACTIVITIES:
Net loss $ (467) $(1,050)
Charges to income not affecting cash:
Depreciation 236 655
Deferred revenues (90) 50
Stock-based compensation 29 --
Imputed interest on ITC penalty 14 --
(Gain) loss on disposal of furniture, fixtures and equipment (8) 7
Net change in receivables, inventories, prepaid expenses, payables and other (533) 1,218
------- -------
NET CASH FROM (USED IN) OPERATING ACTIVITIES (819) 880
INVESTING ACTIVITIES:
Purchases of furniture, fixtures, and equipment (196) --
Proceeds from sales of furniture, fixtures and equipment 8 --
------- -------
NET CASH USED IN INVESTING ACTIVITIES (188) --
FINANCING ACTIVITIES:
Payments on capital lease obligations -- (47)
Proceeds from issuance of Common Stock 2 --
------- -------
NET CASH FROM (USED IN) FINANCING ACTIVITIES 2 (47)
------- -------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (1,005) 833
Cash and cash equivalents at beginning of period 4,756 1,175
------- -------
CASH AND CASH EQUIVALENTS
AT END OF PERIOD $ 3,751 $ 2,008
======= =======
See accompanying notes to consolidated financial statements.
Page 5 of 19
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE A - BASIS OF PRESENTATION
PHOTOWORKS, INC: ("PhotoWorks" or the "Company") is a photo 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 service provides film and image
processing and online image storage and management services to both traditional
and digital camera users, primarily in the United States, which allows customers
to store and organize photos online, share them with friends and family, and
order reprints, photo albums, and photo related products. The Company also
offers an array of complementary products and services, primarily under the
brand name PhotoWorks(R).
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 three-months ended December 27, 2003 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. Cash flow used in operations during the first
quarter of fiscal 2004 was $819,000, primarily due to lower revenues that were
partially offset by lower operating costs. Cash flows from operations were
positive in fiscal 2003 and 2002 primarily due to income tax refunds aggregating
$5,780,000 related to tax net operating loss carrybacks. Management has taken
various actions, including workforce reductions, store closures, and reduced
marketing and administrative expenditures to more closely align its cost
structure with its reduced revenue levels and to improve its cash flows.
Management believes that under current operational plans, its current cash
balances and projected future cash flows from operations will be sufficient to
fund operations through at least the next twelve months. Further, management has
both the ability and intent to undertake additional actions to reduce expenses
to ensure cash balances are sufficient to meet its obligations as they become
due. However, the Company's inability to successfully generate sufficient cash
flow from operations would have a material adverse impact on the Company's
financial position and liquidity and may require the Company to seek additional
sources of funding to enable it continue operations for at least the next twelve
months.
NOTE C - DEFERRED REVENUES
At the end of fiscal 2003, the Company primarily deferred revenue pursuant
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 is 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 film
rolls processed. The Frequent Customer Program expired in January 2004.
Page 6 of 19
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE C - DEFERRED REVENUES (Continued)
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
develop into prints. 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.
In November 2004, the Company 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 December 27, 2003, approximately $100,000 is deferred under each of
these three programs.
NOTE D - 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 E - RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform to the
current year's presentation.
NOTE F - INCOME TAXES
The Company has net deferred tax assets totaling $11,976,000, 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 $11,976,000 has been recorded against net deferred tax
assets.
NOTE G - 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.
On October 20, 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.
Page 7 of 19
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE G - STOCK-BASED COMPENSATION (Continued)
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 1,800,000 shares
of Common Stock at prices equal to the fair market value of the shares at the
time the options are granted.
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.
In February 2004, shareholders approved an amendment to the 1999 Stock
Incentive Compensation Plan, to increase the aggregate number of shares of
Common Stock available for issuance under plan from 1,800,000 shares to
2,300,000 shares.
Shares of Common Stock reserved for issuance under these stock option
plans totaled 3,656,840 at December 27, 2003, of which 524,990 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 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 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 for 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:
December 27, 2003 December 28, 2002
----------------- -----------------
Risk free interest rate 2.44% 2.23%
Expected volatility 185.74% 173.35%
Expected option life 3.18 years 2.84 years
Dividend yield 0.00% 0.00%
Under Statement No. 123, if the Company had elected to recognize the
compensation cost based upon the fair value of the options granted at grant
date, net loss would have been increased as follows:
First Quarter Ended
-------------------------------
December 27, 2003 December 28, 2002
=====================================
Net loss as reported $ (467,000) $(1,050,000)
Add: Stock-based compensation expense
included in net income, net of related tax effects 29,000 --
Deduct: Stock-based compensation as determined
under FAS 123, net of related tax effects (331,000) (150,000)
----------- -----------
Pro forma net loss $ (769,000) $(1,200,000)
=========== ===========
Loss per share as reported $ (.03) $ (.06)
=========== ===========
Pro-forma loss per share $ (.05) $ (.07)
=========== ===========
Page 8 of 19
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE H - 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 loss per
share because their effect was antidilutive.
The following table sets forth the computation of basic and diluted
earnings (loss) per share:
First Quarter Ended
---------------------------------
December 27, 2003 December 28, 2002
=================================================================================================================
Numerator for basic and diluted earnings per share:
Net loss $ (467,000) $ (1,050,000)
Denominator:
Denominator for basic earnings per share - weighted-average shares 16,667,000 16,655,000
Effect of dilutive securities:
Stock options, warrants, convertible preferred shares -- --
------------ ------------
Denominator for diluted earnings per share 16,667,000 16,655,000
============ ============
Net loss per share $ (.03) $ (.06)
============ ============
At December 27, 2003, and December 28, 2002, there were 8,101,946,
7,275,924 stock options, warrants and common stock upon conversion of Series A
preferred shares, respectively, that were excluded from the computation of
diluted 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.
NOTE I - CONTINGENCIES
Fuji Photo Film Co., Ltd - The Company was a defendant in a claim filed by
Fuji Photo Film Co., Ltd. with the International Trade Commission. The
Commission upheld the infringement determination and, in May 2003, upheld a
penalty assessment of $1,600,000.
In September 2003, the Company negotiated a settlement agreement with the
ITC, whereby the Company gives up its appeal rights, to reduce the penalty by
$600,000 to a total of $1,000,000. The settlement also included a payment
schedule of $250,000 in each of the next four years beginning in July 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.
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 ITC 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 and one of its service providers are in discussions relating
to fees billed in connection with services provided. The negotiations are
currently in process but no final agreement has been reached. These disputed
amounts were accrued in the periods in which they were incurred. If the Company
were successful in negotiating a reduction of the amounts, it would recognize
reduced expenses in a future period thereby increasing income for that period.
The Company is also involved in various routine legal proceedings in the
ordinary course of its business.
Page 9 of 19
PHOTOWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE J - SUBSEQUENT EVENT
In January 2004, The Company initiated a reduction in force, representing
approximately 18% of its current workforce and affecting all areas of the
company. The Company will record a charge of approximately $195,000 related to
workforce reductions in its second quarter ending March 27, 2004.
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" or the "Company") is a photo 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 service provides film and image processing and online
image storage and management services to both traditional and digital camera
users, primarily in the United States, which allows customers to store and
organize photos online, share them with friends and family, and order reprints,
photo albums, and photo related products. The Company also offers an array of
complementary products and services, primarily under the brand name
PhotoWorks(R).
The Company incurred a net loss of $467,000 or a loss of $.03 per share in
the first quarter of fiscal 2004, compared to a net loss of $1,050,000, or a
loss of $.06 per share for the first quarter of 2003. Although revenues for the
first quarter of fiscal 2004 declined by approximately 31% compared to the first
quarter of fiscal 2003, the Company reduced its net loss by improving operating
efficiencies and lowering its operating costs.
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.
Page 10 of 19
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, 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 fiscal 2003, we deferred revenues related primarily to a Frequent
Customer Program. Under this program, after processing a certain number of rolls
of film within a stated period of time, a customer receives free processing on
their next roll of film. For each roll of film for which the processing is paid
under this program, we defer a portion of the revenue received and recognize the
revenue upon processing of the free roll, so that revenue from customers in this
program is recognized ratably over all film rolls processed. As of December 27,
2003, we had $100,000 of deferred revenues remaining under this program. The
remaining net deferred revenues under this program will be recognized as revenue
by January 31, 2004, the expiration date of the program.
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 develop into
prints. 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 December 27, 2003, approximately $100,000 is 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 December
27, 2003, approximately $100,000 is deferred under this program.
Deferred Tax Assets
We have net deferred tax assets totaling $11,976,000, 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 $11,976,000 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 I of Notes to Consolidated Financial Statements),
the outcomes of which are subject to significant uncertainty. SFAS 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.
Page 11 of 19
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.
First Quarter Ended
----------------------
December 27, December 28,
2003 2002
================================================================================
Net revenues 100.0% 100.0%
Cost of goods and services 70.4 77.6
----- -----
Gross profit 29.6 22.4
Operating expenses:
Marketing 10.0 11.0
Research and development 8.1 6.4
General and administrative 19.0 17.2
----- -----
Total operating expenses 37.1 34.6
----- -----
Loss from operations (7.5) (12.2)
Total other expense (.6) (.4)
----- -----
Net loss (8.1)% (12.6)%
===== =====
Net revenues for the first quarter of fiscal 2004 were $5,755,000 as
compared to net revenues of $8,353,000 in the first quarter of fiscal 2003. The
decrease in net revenues was primarily due to declines in traditional film
processing volumes, partially offset by growth in digital printing services. In
the first quarter of fiscal 2004, net revenues from digital printing services
increased to approximately 16% of net revenues, or $944,000, compared to 9% of
net revenues, or $752,000, in the first quarter of the prior year. Additionally,
net revenues in the first quarter of fiscal 2003 included approximately $350,000
from sales generated through retail stores. The Company closed its remaining
retail stores in fiscal 2003 to focus resources on digital and online
initiatives. Net revenues in fiscal 2004 are expected to be lower than fiscal
2003 primarily due to lower film processing volumes.
Cost of goods and services consists of labor, postage, supplies and fixed
operating costs related to the Company's services and products. Gross profit in
the first quarter of fiscal 2004 increased to 29.6% of net revenues compared to
22.4% in the first quarter of fiscal 2003. The increase in gross profit is
primarily due to lower labor and materials costs from efficiencies in digital
printing and closing lower-margin retail operations. In addition, margins on
certain digital print services increased due to price increases that were
effective in April 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 first quarter of fiscal 2004 decreased to
$577,000, or 10% of net revenues, compared to $919,000 or 11% of net revenues in
the first quarter of fiscal 2003. Marketing expenditures in the first quarter of
fiscal 2004 were focused on existing customers. Marketing expenses will
fluctuate due to the timing of product introductions.
Research and development expenses decreased to $465,000 for the first
quarter of fiscal 2004 compared to $536,000 in the first quarter of fiscal 2003.
Research and development expenses consist primarily of costs incurred in
developing online photo archiving and photo sharing services, computerized
online image management concepts, other online services, and creating equipment
necessary to provide customers with new digital photographic services and
products.
General and administrative expenses decreased to $1,093,000 for the first
quarter of fiscal 2004 compared to $1,435,000 for the first quarter of fiscal
2003. The decrease was primarily due to lower staffing and professional service
costs as well as a reduction of $135,000 to amounts previously accrued for an
outstanding tax matter. 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.
Page 12 of 19
Total operating expenses in the first quarter of fiscal 2004 were
$2,135,000 or 37.1% of net revenues, compared to $2,890,000 or 34.6% of net
revenues in the first quarter of fiscal 2003. Future periods may reflect
increased or decreased operating costs due the timing and magnitude of marketing
activities and research and development activities.
In January 2004, The Company initiated a reduction in force, representing
approximately 18% of its current workforce and affecting all areas of the
company. PhotoWorks anticipates a total annual cost savings of nearly $1.8
million in salaries and benefits related to workforce reductions. The Company
will record a charge of approximately $195,000 related to workforce reductions
in its second quarter ending March 27, 2004.
Liquidity and Capital Resources
As of January 30, 2004, the Company's principal source of liquidity
included approximately $3,346,000 in cash and cash equivalents. The Company's
current ratio as of December 27, 2003 was 1.43 compared to 1.46 at the end of
fiscal 2003.
In the first quarter of fiscal 2004, the Company had negative cash flows
from operating activities of $819,000, primarily due to payments of liabilities
and expenses accrued at the end of its fiscal year and the net loss for the
quarter. Based on current operating plans, it is anticipated that the Company's
negative operating cash flows will not be as significant in its third and fourth
quarters will be lower primarily due to the timing of promotional activities and
seasonality of the photofinishing season.*
Based on current projections, the Company currently anticipates that
existing cash and cash equivalents and projected future cash flows from
operations will be sufficient to fund its operations, including any capital
expenditures, if any, through at least December 31, 2004.* However, the
Company's inability to successfully generate sufficient cash flow from
operations would have a material adverse impact on the Company's financial
position and liquidity and may be required to seek external sources of financing
or refinance its obligations. There can be no assurance that the Company will be
able to obtain adequate financing.*
Page 13 of 19
PART II -- OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS
For an update concerning the legal proceedings, see Note I of Notes to
Consolidated Financial Statements in Part I above.
ITEM 5 - 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.
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
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 November 19, 2003 - Item 12 - Results of Operations
and Financial Condition for fourth quarter and year ended September
27, 2003.
Page 14 of 19
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: February 10, 2004 /s/ Philippe Sanchez
-------------------------------------
Philippe Sanchez
President and Chief Executive Officer
/s/ Loran Cashmore Bond
-------------------------------------
Loran Cashmore Bond
(Vice President Administration and
Chief Accounting Officer)
Page 15 of 19
INDEX TO EXHIBITS
PHOTOWORKS, INC.
Quarterly Report on Form 10-Q
For The Quarter Ended December 27, 2003
Exhibit Description Page No.
- ------- ----------- --------
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)
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
Page 16 of 19