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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 Fiscal Quarter Ended September 30, 2000
COMMISSION FILE NUMBER 0-27717
SMARTERKIDS.COM, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 04-3226127
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
15 CRAWFORD STREET, NEEDHAM, MA 02494
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (781) 449-7567
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
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 report(s), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
The number of shares outstanding of the registrant's $.01 par value common
stock as of November 13, 2000 was 20,651,115.
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SMARTERKIDS.COM, INC.
QUARTERLY REPORT ON FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 2000
<TABLE>
<CAPTION>
CONTENTS
Item Number Page
----------- ----
<S> <C>
PART I: FINANCIAL INFORMATION............................................. 3
ITEM 1. FINANCIAL STATEMENTS............................................ 3
BALANCE SHEETS AS OF SEPTEMBER 30, 2000 AND DECEMBER 31, 1999
(unaudited).......................................................... 3
STATEMENT OF OPERATIONS FOR THE THREE MONTHS AND THE NINE MONTHS
ENDED SEPTEMBER 30, 1999 AND SEPTEMBER 30, 2000 (unaudited).......... 4
STATEMENT OF CASH FLOWS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 1999
AND THE THREE MONTHS ENDED SEPTEMBER 30, 2000 (unaudited)............ 5
NOTES TO FINANCIAL STATEMENTS.......................................... 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS........................................... 8
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS......................... 12
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...... 21
PART II: OTHER INFORMATION................................................ 22
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS....................... 22
ITEM 5. OTHER INFORMATION............................................... 22
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K................................ 23
SIGNATURES
EXHIBIT INDEX
EXHIBIT 10.1 FORM OF CHANGE OF CONTROL FOR EXECUTIVE OFFICERS
EXHIBIT 10.2 FORM OF CHANGE OF CONTROL FOR SENIOR EXECUTIVE OFFICERS
EXHIBIT 27.1 FINANCIAL DATA SCHEDULE
</TABLE>
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PART I: FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SMARTERKIDS.COM, INC.
BALANCE SHEET
-------------
(In thousands, except share data)
(Unaudited)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
2000 1999
------------ ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents...................... $ 17,754 $ 55,621
Short-term investments......................... 15,201 11,735
Accounts receivable, net of allowance for
doubtful accounts of $22 and $27 at
September 30, 2000 and December 31, 1999,
respectively.................................. 175 132
Inventories.................................... 4,161 8,902
Other current assets........................... 2,573 2,403
-------- --------
Total current assets......................... 39,864 78,793
Property and equipment, net...................... 5,469 2,421
Other assets..................................... 1,761 --
Intangible assets, net........................... 362 621
Restricted cash 1,028 500
-------- --------
Total assets..................................... $ 48,484 $ 82,335
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long term debt and capital
lease obligations............................. $ 541 $ 74
Accounts payable............................... 2,123 10,996
Accrued expenses............................... 2,983 6,699
Deferred revenue............................... 533 811
Other current liabilities...................... 72 87
-------- --------
Total current liabilities.................... 6,252 18,667
Long term debt and capital lease obligations,
net of current portion.......................... 806 34
-------- --------
Total liabilities............................ 7,058 18,701
-------- --------
Commitments and contingencies (Note 4) -- --
Stockholders' equity:
Common stock, $0.01 par value; 90,000,000
shares authorized; 20,641,040 and 20,301,770
shares issued and outstanding at September 30,
2000 and December 31, 1999, respectively...... 206 203
Additional paid-in capital..................... 112,374 112,907
Deferred stock compensation.................... (4,494) (6,286)
Accumulated deficit............................ (66,660) (43,190)
-------- --------
Total stockholders' equity................... 41,426 63,634
-------- --------
Total liabilities and stockholders' equity... $ 48,484 $ 82,335
======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
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SMARTERKIDS.COM, INC.
STATEMENT OF OPERATIONS
-----------------------
(In thousands, except per share data)
(Unaudited)
<TABLE>
<CAPTION>
FOR THE FOR THE
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------- ------------------
<S> <C> <C> <C> <C>
2000 1999 2000 1999
------- ------- -------- --------
Net revenues.............................. $ 1,507 $ 721 $ 4,504 $ 1,108
Cost of revenues.......................... 1,136 516 3,386 795
------- ------- -------- --------
Gross profit.............................. 371 205 1,118 313
------- ------- -------- --------
Operating expenses:
Marketing and sales..................... 5,771 5,013 20,215 10,726
Development............................. 782 328 2,546 1,149
General and administrative.............. 768 750 2,490 1,091
Stock compensation...................... 860 1,209 1,374 1,789
------- ------- -------- --------
Total operating expenses.............. 8,181 7,300 26,625 14,755
------- ------- -------- --------
Loss from operations...................... (7,810) (7,095) (25,507) (14,442)
Interest and other income (expense), net.. 555 248 2,037 300
------- ------- -------- --------
Net loss.................................. (7,255) (6,847) (23,470) (14,142)
Accretion of redeemable preferred stock -- (119) -- (119)
------- ------- -------- --------
Net loss attributable to common
stockholders............................. $(7,255) $(6,966) $(23,470) $(14,261)
======= ======= ======== ========
Basic and diluted net loss per common
share.................................... $ (0.35) $ (3.52) $ (1.15) $ (8.10)
Weighted average shares outstanding-basic
and diluted.............................. 20,607 1,977 20,476 1,760
</TABLE>
The accompanying notes are an integral part of these financial statements.
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SMARTERKIDS.COM, INC.
STATEMENT OF CASH FLOWS
-----------------------
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
FOR THE
NINE MONTHS ENDED
SEPTEMBER 30,
---------------------------
2000 1999
-------- --------
<S> <C> <C>
Cash flows from operating activities:
Net loss . $(23,470) $(14,142)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization.................. 1,368 49
Stock compensation expense..................... 1,374 1,789
Changes in assets and liabilities:
Accounts receivable...................... (43) 708
Inventories.............................. 4,741 104
Other assets............................. (170) (2,986)
Other long-term assets................... (1,761) --
Accounts payable......................... (8,873) 4,186
Accrued expenses......................... (3,716) 1,143
Other current liabilities................ (293) (386)
-------- --------
Net cash used in operating activities.............. (30,843) (9,535)
-------- --------
Cash flows from investing activities:
Purchase of short-term investments ......... (3,466) (5,000)
Purchases of property and equipment......... (4,157) (1,041)
Purchase of intangible assets............... -- (150)
Deposit of restricted cash.................. (528) (500)
-------- --------
Net cash used in investing activities.............. (8,151) (6,691)
-------- --------
Cash flows from financing activities:
Proceeds from long-term borrowings.......... 1,601 --
Repayments of long-term borrowings.......... (362) (59)
Proceeds from issuance of Series C
redeemable preferred stock, net of issuance
costs...................................... -- 25,260
Proceeds from exercise of common stock
options.................................... 25 113
Proceeds from exercise of common stock
warrants................................... 15 --
Proceeds from the purchase of common stock
under the Employee Stock Purchase Plan..... 52 --
Increase from estimated IPO costs........... (204) --
-------- --------
Net cash provided by financing activities ......... 1,127 25,314
-------- --------
Net decrease in cash and cash equivalents ......... (37,867) 9,088
Cash and cash equivalents at beginning of period... 55,621 4,273
-------- --------
Cash and cash equivalents at end of period......... $ 17,754 $ 13,361
======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
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SMARTERKIDS.COM, INC.
NOTES TO FINANCIAL STATEMENTS
-----------------------------
(Unaudited)
1. BASIS OF PRESENTATION:
The interim financial statements as of and for the nine months ended
September 30, 2000 and 1999 have been prepared by SmarterKids.com, Inc.
("SmarterKids.com" or the "Company") pursuant to the rules and regulations of
the Securities and Exchange Commission (the "SEC") for interim financial
reporting. These statements are unaudited and, in the opinion of management,
include all adjustments (consisting only of normal recurring adjustments and
accruals) necessary to present fairly the balance sheet and the statement of
operations and cash flows for the periods presented. Operating results for the
nine months ended September 30, 2000 may not be indicative of the results for
the year ending December 31, 2000. Certain information and footnote disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principles have been omitted in accordance with the rules
and regulations of the SEC. These financial statements should be read in
conjunction with the audited financial statements and accompanying notes
included in the Company's Annual Report on Form 10-K for the year ended December
31, 1999.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosures of
contingencies at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. Actual results could
differ from the estimates.
Marketing and Sales Expenses
Marketing and sales expenses consist primarily of the cost of advertising and
promotional activities, fulfillment costs including service fees to J.L. Hammett
Co., commissions to online marketing companies and expenses for personnel
engaged in marketing and merchandising. Fulfillment costs represent costs
incurred in operating and staffing the distribution center and the customer
service department, picking and packing customer orders for shipment,
responding to inquires from customers, credit card fees, as well as fees paid to
J.L. Hammett Co., a fulfillment partner during the first six months of 2000.
As of July 1, 2000, the Company discontinued using J.L. Hammett Co. as a third
party fulfillment partner due to the opening of its own distribution facility.
Fulfillment costs were $1,111,000 and $203,000 for the quarters ended September
30, 2000 and 1999, respectively, and $1,538,000 and $340,000 for the nine months
ended September 30, 2000 and 1999, respectively. Advertising costs are charged
to operations as incurred. Advertising expenses were $2,553,000 and $3,827,000
for the quarters ended September 30, 2000 and 1999, respectively, and
$10,610,000 and $8,040,000 for the nine months ended September 30, 2000 and
1999, respectively.
Recent Accounting Pronouncements
In December 1999, the SEC staff released Staff Accounting Bulletin ("SAB")
101, "Revenue Recognition in Financial Statements", which provides guidance on
the recognition, presentation and disclosure of revenue in financial statements.
Subsequently, SAB 101 A and B have been released which direct the application of
the guidance in SAB 101 to be required in the Company's fourth quarter of 2000.
The effects of applying this guidance, if any, will be reported as a cumulative
effect adjustment resulting from a change in accounting principle. The Company
does not expect the adoption of SAB 101 to have a material effect on its
financial statements, however, the final evaluation of SAB 101 with respect to
the Company is not yet complete.
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities" as amended by SFAS No. 138, which
was issued in June 2000. The Company will adopt SFAS No. 133 on January 1,
2001. SFAS No. 133 requires that all derivative instruments be reported on the
balance sheet at their fair value. Changes in the fair value of derivatives are
recorded each period in current earnings or other comprehensive income,
depending on whether a derivative is designated as part of a hedge transaction
and, if it is, the type of hedge transaction. The
6
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SMARTERKIDS.COM, INC.
NOTES TO FINANCIAL STATEMENTS--(CONTINUED)
Company has not yet determined the impact of the adoption of SFAS No. 133 on its
financial condition, results of operations, or business practices.
In March 2000, the Emerging Issues Task Force ("EITF") of the FASB reached a
consensus on EITF Issue 00-2, "Accounting for Web Site Development Costs."
This consensus provided guidance on what types of costs incurred to develop web
sites should be capitalized or expensed. The Company adopted this consensus on
July 1, 2000. The adoption of this consensus had no material impact on the
Company's financial statements.
2. PROPERTY AND EQUIPMENT:
Property and equipment consist of the following (in thousands):
<TABLE>
<CAPTION>
September 30, December 31,
2000 1999
------ ------
<S> <C> <C>
Software................................. $1,769 $ 377
Furniture and fixtures................... 230 207
Computer and office equipment............ 3,928 1,774
Leasehold improvements................... 1,095 507
------ ------
7,022 2,865
Less--Accumulated depreciation and
amortization............................ 1,553 444
------ ------
$5,469 $2,421
====== ======
</TABLE>
During April 2000, the Company entered into a lease agreement for a new
distribution facility. As of September 30, 2000, there was $3,114,000 of
capital costs associated with the opening of the new distribution facility held
in fixed assets. The five-year lease requires minimum annual payments of
approximately $900,000.
3. EQUIPMENT LINE OF CREDIT:
During the quarter ended March 31, 2000, the Company secured a three-year
equipment line of credit facility. Through September 30, 2000, borrowings and
equipment collateralized under this agreement were $1.5 million. The interest on
the agreement is the three-year U.S. Treasury rate plus 3.5%. In accordance with
the agreement, the balance under the line of credit was converted to a 36-month
term loan at the time of funding. Accordingly, the Company is making payments of
approximately $45,000 per month over the term of the loan. At September 30,
2000, a total balance of $1.2 million remains outstanding and no additional
amounts are available under the line.
During the quarter ended June 30, 2000, the Company secured additional
borrowing capacity of $1.0 million under another three-year equipment line of
credit facility. Equipment collateralized under this agreement were $149,000.
The interest on the borrowings is 9% per annum. The Company issued warrants for
the purchase of 16,667 shares of common stock with an exercise price of $3.00
per share in connection with obtaining the facility. The warrants have been
valued and a discount of $8,645 has been recorded on the lease obligation. The
discount is being amortized to interest expense over the life of the line of
credit. At September 30, 2000, a balance of $131,000 remains outstanding.
4. COMMITMENTS AND CONTINGENCIES:
Restricted Time Deposit
In connection with a facility lease entered into in 1999, the Company is
required to maintain, on behalf of the landlord, a certificate of deposit in the
amount of $500,000, which is restricted as to its use. In connection with the
warehouse facility lease entered into in the second quarter of 2000, the Company
was required to maintain, on behalf of the landlord, $500,000 in an interest-
bearing account, which will be restricted as to its use.
7
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5. STOCKHOLDERS' EQUITY:
In March 2000, the Financial Accounting Standard Board ("FASB") issued
FASB Interpretation No. 44, "Accounting for Certain Transactions Involving Stock
Compensation - an interpretation of APB Opinion No. 25" ("FIN 44"). FIN 44
clarifies the application of Accounting Policy Bulletin ("APB") APB Opinion
No. 25 and among other issues clarifies the following: the definition of an
employee for purposes of applying APB Opinion No. 25, the criteria for
determining whether a plan qualifies as a noncompensatory plan, the accounting
consequence of various modifications to the terms of previously issued fixed
stock options or awards, and the accounting for an exchange of stock
compensation awards in a business combination. FIN 44 is effective July 1, 2000,
but certain conclusions in FIN 44 cover specific events that occurred after
either December 15, 1998 or January 12, 2000.
On September 7, 2000, the Company completed a direct repricing of certain
employee stock option grants. As part of the repricing, the Company reduced the
exercise price of all outstanding options with exercise prices of greater than
$1.50 per share. The new exercise price of these repriced options was reset to
$1.50 per share, which was equal to the market value of the Company's common
stock on September 7, 2000. The number of options repriced totaled 2,325,574.
The Company is accounting for the repriced options as a variable award. In the
quarter ending September 30, 2000, the Company recorded an incremental non-cash
stock compensation charge of $110,000 as a result of the repricing.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Management's Discussion and Analysis of Financial Condition and Results of
Operations should be read in conjunction with the accompanying financial
statements for the periods specified and the associated notes. Further reference
should be made to the Company's Annual Report on Form 10-K for the period ending
December 31, 1999.
The following discussion contains forward-looking statements which involve risks
and uncertainties. SmarterKids.com makes such forward-looking statements under
the provision of the "Safe Harbor" section of the Private Securities Litigation
Reform Act of 1995. Any forward-looking statements should be considered in
light of the factors described below in this Item 2 under "Certain Factors That
May Affect Future Results." Actual results may vary materially from those
projected, anticipated or indicated in any forward-looking statements. In this
Item 2, the words "anticipates," "believes," "expects," "intends," "future,"
"could," and similar words or expressions (as well as other words or expressions
referencing future events, conditions, or circumstances) identify forward-
looking statements. The following discussion and analysis should be read in
conjunction with the accompanying financial statements and related notes
included elsewhere in this Quarterly Report on Form 10-Q.
OVERVIEW
SmarterKids.com is a leading online educational store dedicated to helping
parents help their children learn, develop, and grow. The site offers the
Internet's most personalized shopping experience, linking teacher-reviewed toys,
games, books, software, and hands-on activities through SmarterKids.com's
patent-pending evaluation and recommendation process. The Company serves as a
resource for parents, offering specialty centers, the Grade Expectations! guide
to education standards and thousands of educational products, including both
well-known brands and hard-to-find quality offerings, for children aged infant
through 15.
RECENT EVENTS
The Company's recent initiatives include:
. SmarterKids.com launched its State Test Prep Center providing parents with
essential standardized testing information for all 50 states.
8
<PAGE>
. SmarterKids.com introduced its Grandparents Center featuring product
recommendations, news, and gift-giving advice for grandparents. The Center
offers a variety of shopping and browsing options that make selecting the
perfect gift as easy as possible.
. SmarterKids.com introduced school supplies to its product mix. As a
convenience for parents, SmarterKids.com's educators selected school supplies
for children, preschool through grade nine, and also created Back-To-School
Essential Kits and Fun Kits, containing grade-appropriate tools for school.
. SmarterKids.com partnered with Riverdeep Group to offer the latter's online,
subscription-based learning applications including its flagship math
courseware, "Destination MATH" to hundreds of thousands of customers,
creating a new source of revenue for both partners. Through this partnership,
SmarterKids.com will also recommend products to complement the Riverdeep
learning program.
RESULTS OF OPERATIONS
Revenues. Revenues in fiscal 2000 and 1999 primarily consist of online sales
of third-party educational products and charges to customers for shipping. Also
included in fiscal 2000 and 1999 revenues are sales of our proprietary CD-ROM
products, which we offer on a limited basis. The revenue for the quarter ended
September 30, 2000 also includes revenue related to gift certificates previously
sold to a third party which expired unused. In the quarters and nine months
ended September 30, 2000 and 1999, we continued to derive substantially all of
our revenues from sales within the United States. Revenues are recognized upon
shipment to the customer and are net of promotional discounts, coupons and
return allowances, which are determined by historical trends of actual returns.
Revenues were $1.5 million and $721,000 in the quarters ended September 30,
2000 and 1999, respectively, and $4.5 million and $1.1 million in the nine
months ended September 30, 2000 and 1999, respectively. In the quarter and nine
months ended September 30, 2000, we recognized $228,000 of previously deferred
gift certificate revenue on gift certificates expiring unused. The increase in
revenue in the quarter ended September 30, 2000 from the quarter ended September
30, 1999 and in the nine months ended September 30, 2000 from the nine months
ended September 30, 1999 resulted from increased marketing efforts and brand-
building during the more recent periods as well as revenue recognized from
expired coupons.
Cost of revenues. Cost of revenues consists primarily of the cost of products
sold to customers and the cost of shipping products to our customers. We
anticipate that our gross margins will fluctuate from quarter to quarter
depending on consumer preferences for our mix of products. The cost of revenues
was $1.1 million and $516,000 in the quarters ended September 30, 2000 and 1999,
respectively, and $3.4 million and $795,000 in the nine months ended September
30, 2000 and 1999, respectively. During the quarter ended September 30, 2000,
the Company recorded an inventory obsolescence charge of $209,000 for software
products held in inventory. The increase in cost of revenues in the quarter
ended September 30, 2000 from the quarter ended September 30, 1999 and in the
nine months ended September 30, 2000 from the nine months ended September 30,
1999 was principally attributable to growth in online sales. Our gross margin
decreased to 25% in each of the 2000 periods from 28% in each of the 1999
periods due to slightly lower gross margins on new products introduced,
obsolescence charges and increased freight charges.
Marketing and sales. Marketing and sales expenses consist primarily of the
cost of advertising and promotional activities, fulfillment costs, commissions
to online marketing companies expenses for personnel engaged in marketing, and
merchandising activities. Fulfillment costs represent costs incurred in
operating and staffing the distribution center and the customer service
department, picking and packing customers' orders for shipment, responding to
inquires from customers, credit card fees, as well as fees paid to J.L. Hammett
Co., a fulfillment partner during the first six months of 2000. As of July 1,
2000, the Company discontinued using J.L. Hammett Co. as a third party
fulfillment partner due to the opening of its own distribution facility.
9
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Marketing and sales expenses were $5.8 million and $5.0 million in the
quarters ended September 30, 2000 and 1999, respectively, and $20.2 million and
$10.7 million in the nine months ended September 30, 2000 and 1999,
respectively. The increase in the quarter ended September 30, 2000 from the
quarter ended September 30, 1999 and in the nine months ended September 30, 2000
from the nine months ended September 30, 1999 was primarily attributable to
increased advertising and promotional activities, fees to our previous
fulfillment partner, J.L. Hammett Co., as well as the hiring of employees to
staff our distribution center which opened for operations July 1, 2000.
Fulfillment costs included in marketing and sales expense were $1,111,000 and
$203,000 for the quarters ended September 30, 2000 and 1999, respectively, and
$1,538,000 and $340,000 for the nine months ended September 30, 2000 and 1999,
respectively.
In September 2000, the EITF reached a final consensus on EITF Issue 00-10,
"Accounting for Shipping and Handling Fees and Costs." This consensus states
that all amounts billed to a customer in a sale transaction related to shipping
and handling, if any, represent revenue and should be classified as revenue. We
already classify shipping charges to customers as revenue. With respect to the
classification of costs related to shipping and handling incurred by the seller,
including fulfillment costs, the EITF determined that the classification and
amount of such costs is an accounting policy decision that should be disclosed.
We classify fulfillment costs in marketing and sales expenses. These costs are
primarily composed of distribution facility expenses, including equipment and
supplies, payroll and travel expenses for personnel engaged in distribution
activities, third party fulfillment fees, credit card fees and the costs of
customer support. These costs represent facility costs necessary for warehousing
inventory, as well as costs incurred to pick and pack a customer order and the
related packaging supplies.
Development. Development expenses consist primarily of payroll and related
costs for personnel performing website design, development, maintenance and
testing. Development expenses were $782,000 and $328,000 in the quarters ended
September 30, 2000 and 1999, respectively, and $2.5 million and $1.1 million in
the nine months ended September 30, 2000 and 1999, respectively. The increase
in the quarter ended September 30, 2000 from the quarter ended September 30,
1999 and in the nine months ended September 30, 2000 from the nine months ended
September 30, 1999 was attributable primarily to costs related to maintaining,
testing and enhancing the features, content and functionality of our website, as
well as the hiring of additional employees.
General and administrative. General and administrative expenses consist
primarily of payroll and related costs for executive and administrative
personnel, professional service expenses and other general corporate expenses.
General and administrative expenses were $768,000 and $750,000 in the quarters
ended September 30, 2000 and 1999, respectively, and $2.5 million and $1.1
million in the nine months ended September 30, 2000 and 1999, respectively.
The increase in the quarter ended September 30, 2000 from the quarter ended
September 30, 1999 and in the nine months ended September 30, 2000 from the nine
months ended September 30, 1999 was attributable primarily to the costs related
to the expansion of our operations and infrastructure, as well as the hiring of
additional employees.
Stock compensation. We recorded non-cash stock compensation expense of
$860,000 and $1.2 million in the quarters ended September 30, 2000 and 1999,
respectively, and $1.4 million and $1.8 million in the nine months ended
September 30, 2000 and 1999, respectively, related to amortization of deferred
stock compensation for options and warrants granted to employees and non-
employees. Included in the quarter ended September 30, 2000 was deferred stock
compensation of $242,000 recorded in connection with the acceleration of
J.L. Hammett warrants and $110,000 recorded in connection with the repricing of
certain of our employee stock options.
On September 7, 2000, the Company completed a direct repricing of certain
employee stock option grants. As part of the repricing, the Company reduced the
exercise price of all outstanding options with exercise prices of greater than
$1.50 per share. The new exercise price of these repriced options was reset to
$1.50 per share, which was equal to the market value of the common stock on
September 7, 2000. The number of options repriced totaled 2,325,574. The
Company is accounting for the repriced options as a variable award. In the
quarter ending September 30, 2000, the Company recorded an incremental non-cash
stock compensation charge of $110,000 as a result of the repricing.
10
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Interest and other income (expense), net. Interest and other income
(expense), net consists primarily of interest income earned on our short-term
investments offset by interest expense related to short-term lease obligations
and borrowings under our equipment line of credit. Interest and other income
(expense), net increased to $555,000 in the quarter ended September 30, 2000
from $248,000 in the quarter ended September 30, 1999 and to $2.0 million in the
nine months ended September 30, 2000 from $300,000 in the nine months ended
September 30, 1999. The increase was primarily attributable to an increase in
interest income generated from higher balances of capital invested in commercial
paper, corporate and treasury notes and auction rates. The higher balances of
capital were generated from our initial public offering.
LIQUIDITY AND CAPITAL RESOURCES
Since our inception, we have incurred significant losses. We have met our
cash requirements primarily through the sale of capital stock and the use of
capital leases. We received capital from investors in three private venture
capital financings totaling $37.0 million through July 1999. On November 23,
1999, we completed an initial public offering of 4,500,000 shares of common
stock resulting in net proceeds of $65.9 million. The primary purposes of the
initial public offering were to increase our capitalization and financial
flexibility, create a public market for SmarterKids.com's common stock, and
facilitate future access to public markets. As of September 30, 2000, we have
used $32.9 million of the offering proceeds for working capital.
Net cash used in operating activities was $30.8 million and $9.5 million in
the nine months ended September 30, 2000 and 1999, respectively. The increase
in net cash used in operating activities from the nine months ended September
30, 1999 to the nine months ended September 30, 2000 was primarily attributable
to a larger net loss and payments to vendors for inventory, advertising expenses
and the build out of our new distribution center. We expect that operating cash
requirements will increase and that a significant portion of our cash used in
operating activities will be attributable to investments in inventory and
advertising.
Net cash used in investing activities has been primarily for purchases of
fixed assets and short-term investments. Cash used in investing activities was
$8.2 million and $6.7 million in the nine months ended September 30, 2000 and
1999, respectively. The increase in cash used in investing activities was
primarily attributable to increased purchases of equipment for the build-out of
our new distribution facility and the purchase of short-term investments.
Net cash provided by financing activities was $1.1 million and $25.3 million
in the nine months ended September 30, 2000 and 1999, respectively. Net cash
provided by financing activities in the nine months ended September 30, 2000
primarily reflects the net proceeds of $1.6 million from an equipment line of
credit. Net cash provided by financing activities in the nine months ended
September 30, 1999 consisted of proceeds from the exercise of stock options.
During the first quarter of 2000, we entered into a $1.5 million three-year
equipment line of credit facility. Equipment collateralized under this agreement
approximates $1.5 million at September 30, 2000. The interest on the agreement
is equal to the three-year U.S. Treasury rate plus 3.5%. We are making payments
on this credit facility of $45,000 per month.
During the second quarter of 2000, we entered into a lease agreement for a
140,000 square foot distribution center in Mansfield, Massachusetts. The
distribution center allows us to better manage our fulfillment process. As a
result, we discontinued using J.L. Hammett Co. as its fulfillment partner during
the second quarter of 2000. The five-year operating lease for the warehouse will
require minimum payments of approximately $900,000 per year.
As of September 30, 2000, we had $17.8 million of cash and cash equivalents
and $15.2 million of short-term investments. As of that date, our principal
commitments consisted of obligations outstanding under an equipment line of
credit and capital leases in the amount of $1.3 million, commitments for annual
facility lease obligations of $20.0 million, and accounts payable of
$2.1 million. We anticipate that our business model will require us to commit
significant resources to aggressively promote our brand, expand our product and
service offerings and enhance our infrastructure.
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We currently anticipate that current cash, cash equivalents and short-term
investments will be sufficient to meet our anticipated needs for working capital
and capital expenditures through the next twelve months. We anticipate that we
are likely to need additional financing to execute our business model after such
twelve months, or sooner if we need to respond to business contingencies such as
lower-than-anticipated revenues, funding additional advertising expenditures,
developing new or enhancing existing content, features or services, enhancing
our operating infrastructure, responding to competitive pressures, or acquiring
complementary businesses or technologies. We have transitioned customer order
fulfillment to our own distribution facility during the second quarter in 2000.
In conjunction with this transaction, we invested capital for the infrastructure
to support these fulfillment activities at the new distribution facility. If we
raise additional funds through the issuance of equity or convertible debt
securities, the percentage ownership of our stockholders may be reduced, and
these newly issued securities may have rights, preferences or privileges senior
to those of existing stockholders. We cannot be certain that additional
financing will be available to us on favorable terms when required, or at all.
RECENT ACCOUNTING PRONOUNCEMENTS
In December 1999, the SEC staff released SAB 101, "Revenue Recognition in
Financial Statements", which provides guidance on the recognition, presentation
and disclosure of revenue in financial statements. Subsequently, SAB 101 A and B
have been released which direct the application of the guidance in SAB 101 to be
required in our fourth quarter of 2000. The effects of applying this guidance,
if any, will be reported as a cumulative effect adjustment resulting from a
change in accounting principle. We do not expect the adoption of SAB 101 to have
a material effect on our financial statements, however, the final evaluation of
SAB 101 with respect to the Company is not yet complete.
In June 1998, FASB issued SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities"as amended by SFAS No. 138, which was issued in June
2000. The Company will adopt SFAS No. 133 on January 1, 2001. SFAS No. 133
requires that all derivative instruments be reported on the balance sheet at
their fair value. Changes in the fair value of derivatives are recorded each
period in current earnings or other comprehensive income, depending on whether a
derivative is designated as part of a hedge transaction and, if it is, the type
of hedge transaction. The Company has not yet determined the impact of adoption
of SFAS No. 133 on its financial condition, results of operations, or business
practices.
In March 2000, the EITF of the FASB reached a consensus on EITF Issue 00-2,
"Accounting for Web Site Development Costs." This consensus provided guidance on
what types of costs incurred to develop web sites should be capitalized or
expensed. The Company adopted this consensus on July 1, 2000. The adoption of
this consensus had no material impact on the Company's financial statements.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS
OUR BUSINESS IS DIFFICULT TO EVALUATE BECAUSE WE HAVE BEEN OPERATING UNDER OUR
NEW BUSINESS MODEL FOR LESS THAN TWO YEARS. OUR MARKET MAY NOT DEVELOP AS
ANTICIPATED, AND WE MAY NOT SUCCESSFULLY EXECUTE OUR BUSINESS STRATEGY.
We have a limited operating history upon which you can evaluate our business.
We did not launch the SmarterKids.com website and begin selling children's
educational products online until November 1998. In addition, most of our
management team was hired within the last two years. From inception through
March 1998, our activities consisted primarily of the conception, development,
publishing, marketing and sales of proprietary educational and entertainment
CD-ROM software. In March 1998, we began transitioning our business model to
online sales of third-party educational products. In November 1998, we launched
our website, ceased the sale of our proprietary CD-ROM products through
traditional retail channels and now offer our proprietary CD-ROM products on a
limited basis through our online channel.
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We cannot be certain that our business strategy will be successful or that we
will successfully address these and other challenges, risks and uncertainties.
OUR LIMITED OPERATING HISTORY MAKES FORECASTING DIFFICULT. WE MAY BE UNABLE TO
ADJUST OUR SPENDING IN A TIMELY MANNER TO COMPENSATE FOR ANY UNEXPECTED REVENUE
SHORTFALL.
As a result of our limited operating history with our current business model
introduced in November 1998, it is difficult to accurately forecast future
revenues. Also, we have limited meaningful historical financial data upon which
to base planned operating expenses. We base our current and future expense
levels on our operating plans and estimates of future revenue. Revenue and
operating results are difficult to forecast because they generally depend on the
volume and timing of the orders we receive. As a result, we may be unable to
adjust our spending in a timely manner to compensate for any unexpected revenue
shortfall, which would result in further substantial losses. We may also be
unable to expand our operations in a timely manner to adequately meet customer
demand to the extent it exceeds our expectations.
WE HAVE A HISTORY OF LOSSES, AND WE EXPECT TO INCUR SUBSTANTIAL NET LOSSES IN
THE FUTURE. IF WE DO NOT ACHIEVE PROFITABILITY, OUR FINANCIAL CONDITION AND OUR
STOCK PRICE COULD SUFFER.
Since inception, we have incurred significant losses. As of September 30,
2000, we had an accumulated deficit of $66.6 million. We incurred a net loss of
$23.5 million for the nine months ended September 30, 2000. We expect operating
losses and negative cash flow to continue for the foreseeable future.
Our ability to become profitable depends on our ability to generate and
sustain higher revenue while maintaining reasonable expense levels.
We anticipate sales growth will moderate during the remainder of the year as we
reduce our marketing investment and focus on those programs that bring us the
most loyal customers. Our focus is on cost-effective top line growth, attracting
the most profitable traffic, new customer acquisition, and reaching
profitability. These efforts may not be effective in converting a large number
of customers from traditional shopping methods to online shopping for
educational products and services or attracting online customers to our website.
In addition, we are obligated to pay commissions based on a percentage of
revenue to companies with which we have online marketing relationships. Through
May 2000, we paid our fulfillment services provider, J.L. Hammett Co., a fee
based on a fixed percentage of the costs of our products to us and will incur
operating expenses related to fulfillment activities in our new distribution
center that opened in June 2000. Some of these costs will increase as our
revenues and orders increase. If we do achieve profitability, we cannot be
certain that we will be able to sustain or increase profitability on a quarterly
or annual basis in the future.
WE EXPECT OUR QUARTERLY OPERATING RESULTS TO FLUCTUATE. IF WE FAIL TO MEET THE
EXPECTATIONS OF PUBLIC MARKET ANALYSTS AND INVESTORS, THE MARKET PRICE OF OUR
COMMON STOCK WILL DECLINE.
If our quarterly revenue or operating results fall below investor or
securities analyst expectations, our stock price could fall substantially. The
Company's operating results may fall below investor or analyst expectations
irregardless of the Company's success or profitability. Factors that may cause
our operating results to fluctuate include:
. decreases in the number of visitors to our website or our inability to
convert visitors on our website to customers
. the mix of children's educational books, toys and games, and software sold by
us
. seasonality due to the academic year and holiday season
. our inability to manage supplier or distributor relationships
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. price competition
. an increase in the level of product returns
. increases in the cost of advertising
. the amount and timing of operating costs and capital expenditures relating to
expansion of our operations
. unexpected increases in shipping costs and delivery times, particularly
during the holiday season
. technical difficulties or system interruptions
In addition, general economic conditions and fluctuations in the demand for
children's educational product, over which we have no control, may also cause
our operating results to fluctuate.
Many of the other risk factors listed in this Quarterly Report on Form 10-Q
may negatively affect our quarterly operating results and contribute to
fluctuations. Our limited operating history makes it difficult to assess the
impact of these factors on our operating results. Because of this difficulty in
predicting future performance, our operating results will likely fall below the
expectations of securities analysts or investors in some future quarter or
quarters, which would likely adversely affect the market price of our common
stock.
OUR MARKET IS HIGHLY SEASONAL AND MAY CAUSE OUR OPERATING RESULTS TO FLUCTUATE
FROM QUARTER TO QUARTER. OUR ANNUAL RESULTS ARE HIGHLY DEPENDENT ON THE SUCCESS
OF OUR HOLIDAY SELLING SEASON.
The market for children's educational books, toys and games, and software is
highly seasonal increasing significantly during the holiday season. In addition,
Internet usage generally declines in the summer. Accordingly, we expect to
experience seasonal fluctuations in our revenue. In particular, we expect a
disproportionate amount of our revenue to be realized during any quarter of each
calendar year. If for any reason our revenue is below expectations during the
fourth quarter, our annual operating results would be adversely affected.
In the future, our seasonal sales patterns may become more pronounced, may
strain our personnel and fulfillment relationships and may cause a shortfall in
revenue as compared to expenses in a given period. These seasonal patterns will
cause quarterly fluctuations in our operating results and could adversely affect
our financial performance.
WE PAY COMMISSIONS TO COMPANIES WITH WHICH WE HAVE ONLINE MARKETING
RELATIONSHIPS. OUR PROFITS AS A PERCENTAGE OF REVENUES WILL DECREASE AS THE
PROPORTION OF OUR REVENUES FROM THESE ARRANGEMENTS INCREASES.
Our relationships with online companies are intended to drive traffic to our
website. Approximately 5% of our revenues in the quarter ended September 30,
2000 was derived from these relationships. We pay commissions to these companies
based on a percentage of the revenues we derive from these relationships.
Although these relationships are intended to increase the number of our
customers and, therefore, our revenues, as revenues derived from these
relationships increases, our profit as a percentage of revenues will decrease.
WE FACE SIGNIFICANT INVENTORY RISKS BECAUSE CONSUMER DEMAND CAN CHANGE FOR
PRODUCTS THAT WE HAVE IN INVENTORY OR ON ORDER.
The demand for certain products can change what we have in inventory or on
order. As a result, we may own inventory that may become obsolete if customer
orders do not materialize. This risk may be greatest in the first calendar
quarter of each year, after we have significantly increased our inventory levels
for the prior holiday season. This risk will increase as we enter into new
product categories due to our lack of experience in purchasing products for
these categories. In addition, to the extent that demand for our products
increases over time, we may be forced to increase inventory levels. Any such
increase would subject us to additional inventory risks.
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THE INABILITY TO PERFORM OUR OWN DISTRIBUTION SERVICES COULD LEAD TO
INTERRUPTIONS IN OUR OPERATIONS, LOST REVENUES AND INCREASED EXPENSE.
In June 2000, we moved our order fulfillment from a third party partner,
J.L. Hammett Co., to our own distribution facility in Mansfield, Massachusetts.
Our inability to manage our distribution center could lead to interruptions in
our operations, lost revenues and increased expense.
OUR BUSINESS RELIES ON OUR ABILITY TO OBTAIN SUFFICIENT QUANTITIES OF QUALITY
MERCHANDISE ON ACCEPTABLE COMMERCIAL TERMS.
Vendors may stop selling merchandise to us and we may not be able to secure
identical or comparable merchandise from alternative vendors in a timely manner
or on acceptable terms. From time to time, we expect to experience difficulty in
obtaining sufficient quantities of certain products. If we cannot supply our
products to consumers at acceptable prices, we may lose sales and market share
as consumers make purchases elsewhere. Further, an increase in supply costs
could increase operating losses beyond current expectations.
INTELLECTUAL PROPERTY CLAIMS AGAINST US CAN BE COSTLY AND RESULT IN THE LOSS OF
SIGNIFICANT RIGHTS.
We regard trademarks, copyrights, service marks, trade secrets, patents and
similar intellectual property as important to our success. We rely on trademark
and copyright law, trade secret protection and confidentiality and/or license
agreements with our employees, customers and others to protect our proprietary
rights.
Other parties may assert infringement or unfair competition claims against us.
In the past, other parties have sent us notice of claims of infringement of
proprietary rights, including trademarks, copyrights and patents related to our
business, and we may receive other notices in the future. If we are forced to
defend against any such claims, whether they are with merit or are determined in
our favor, then we may face costly litigation, diversion of technical and
management personnel and product shipment delays. If there is a successful claim
of infringement against us and we are unable to develop non-infringing
technology or license the infringed or similar technology on a timely basis, or
if we are required to cease using one or more of our business or product names
due to a successful trademark infringement claim against us, it could adversely
affect our business.
In addition, effective trademark, service mark, copyright, trade secret and
patent protection may not be available in every country in which we sell our
products and services online. Therefore, the steps we take to protect our
proprietary rights may be inadequate and our business could be adversely
affected.
IF WE ARE UNABLE TO RETAIN OR ACQUIRE THE NECESSARY DOMAIN NAMES, OUR BRAND AND
REPUTATION COULD BE DAMAGED AND WE COULD LOSE CUSTOMERS.
We currently hold the web domain name SmarterKids.com as well as several other
variations of this domain name. The acquisition and maintenance of domain names
generally is regulated by governmental agencies and their designees. In the
United States, the National Science Foundation has appointed Network Solutions,
Inc., and recently several others, as the current registrars for the ".com",
".net" and ".org" generic top-level domains. The regulation of domain names
in the United States and in foreign countries is subject to change in the near
future. As a result, we may be unable to acquire or maintain relevant domain
names in all countries in which we conduct business. Furthermore, the
relationship between regulations governing domain names and laws protecting
trademarks and similar proprietary rights is unclear. Therefore, we may be
unable to prevent third parties from acquiring domain names that are similar to,
infringe upon or otherwise decrease the value of our trademarks and other
proprietary rights. In addition, other parties hold domain names that are
similar to ours. Any confusion of our website with another party's could
diminish our brand.
WE MAY FAIL TO COMPETE EFFECTIVELY IN OUR MARKET.
The market for children's educational products online is new, rapidly evolving
and intensely competitive. We expect competition to intensify in the future.
Barriers to entry are minimal and current and new competitors can launch new
websites at a relatively low cost. In addition, the markets for children's
books, toys and games, and
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software in general, including those for children's educational products, are
very competitive and highly fragmented, with no clear dominant leader and
increasing public and commercial attention.
Our competitors can be divided into several groups, including:
. mass market retail chains, such as Kmart, Target and Wal-Mart
. mass market book sellers, toy stores and computer hardware and software
stores, such as Barnes & Noble, Toys "R" Us and CompUSA
. traditional regional or local bookstores, toy stores and computer and
software stores
. traditional specialty educational retailers, such as Learning Express and
Zany Brainy
. online book sellers, toy sellers and computer software sellers, such as
Amazon.com, eToys, KBkids.com and Beyond.com
. educational catalog distributors, such as Scholastic
Many of our current and potential competitors have longer operating histories,
larger customer or user bases, greater brand recognition and significantly
greater financial, marketing and other resources than we do. Our competitors
may be able to secure products from vendors on more favorable terms, fulfill
customer orders more efficiently and adopt more aggressive pricing or inventory
availability policies than we can. Traditional store-based retailers also
enable customers to see and feel products in a manner that is not possible over
the Internet. Some of our competitors have significantly greater experience in
selling children's educational products. Many of these current and potential
competitors can devote substantially greater resources to marketing and
promotional campaigns and website and systems development than we can. Their
financial strength could prevent us from increasing market share. In addition,
larger, more well-established and better financed entities are acquiring,
investing in and forming joint ventures with online competitors and publishers
or suppliers of children's educational books, toys and games and software as the
use of the Internet increases. Increased competition may result in reduced
operating margins, loss of market share and diminished brand awareness.
IF WE ENTER NEW BUSINESS CATEGORIES AND PURSUE NEW PRODUCT OFFERINGS AND
SERVICES THAT DO NOT ACHIEVE MARKET ACCEPTANCE, OUR BRAND AND REPUTATION COULD
BE DAMAGED AND WE COULD INCUR ADDITIONAL FINANCIAL LOSSES.
We may choose to expand our operations by expanding the breadth and depth of
products and services offered or expanding our market presence through
relationships with third parties. In addition, we may pursue the acquisition of
new or complementary businesses, products, services or technologies, although we
have no present understandings, commitments or agreements with respect to any
material acquisitions or investments. We may not be successful in our efforts to
expand our operations, and potential customers may not react favorably to these
efforts. Furthermore, any new product or service category that is launched by us
but not favorably received by consumers could damage our brand or reputation. An
expansion of our business would also require significant additional expenses,
expose us to additional supplier/distributor inventory risk and strain our
management, financial and operational resources. Given our lack of capital
resources, any expansion program or new business category that is not successful
could strain our financial resources and detract capital from otherwise
successful operations.
IF WE ARE UNABLE TO MANAGE OUR GROWTH AND THE RELATED EXPANSION IN OUR
OPERATIONS EFFECTIVELY, OUR BUSINESS MAY BE HARMED.
Our ability to successfully offer products and services and implement our
business model in a rapidly evolving market requires an effective planning and
management process. We continue to increase the scope of our operations and have
grown our headcount substantially. Excluding part-time employees, we have grown
from 15 employees at December 31, 1997 to 133 employees at September 30, 2000.
We will need additional personnel in the future. We may be unable to hire
qualified employees as needed. Our growth has placed, and our anticipated
future operations will continue to place, a significant strain on our
management, information systems, network and other resources.
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WE DEPEND UPON UNITED PARCEL SERVICE AND THE UNITED STATES POSTAL SERVICE TO
DELIVER OUR PRODUCTS ON A TIMELY AND CONSISTENT BASIS. A DETERIORATION IN OUR
RELATIONSHIP WITH EITHER CARRIER COULD DECREASE OUR ABILITY TO TRACK SHIPMENTS,
CAUSE SHIPMENT DELAYS AND INCREASE OUR SHIPPING COSTS AND THE NUMBER OF DAMAGED
PRODUCTS.
Our supply and distribution system is dependent upon our relationship with
United Parcel Service and the United States Postal Service. If either
relationship is terminated or impaired or if either carrier is unable to deliver
product for us, whether through labor shortage, slow down or stoppage,
deteriorating financial or business condition or for any other reason, we would
be required to use alternative carriers for the shipment of products to our
customers. We may be unable to engage an alternative carrier on a timely basis
or upon terms favorable to us. Potential adverse consequences of changing
carriers include:
. reduced visibility into order status and package tracking
. delays in order processing and product delivery
. increased cost of delivery, resulting in reduced gross margins
. reduced shipment quality which may result in damaged products and customer
dissatisfaction
IF WE DO NOT SUCCESSFULLY MAINTAIN AND EXPAND OUR WEBSITE AND THE SYSTEMS THAT
PROCESS CUSTOMERS' ORDERS, WE COULD LOSE CUSTOMERS AND OUR REVENUES COULD BE
REDUCED.
Our success, in particular our ability to successfully receive and fulfill
orders and provide high quality customer service, largely depends on the
efficient and uninterrupted operation of our computer and communications
systems. As of June 2000, all orders are fulfilled at our own distribution
center in Mansfield, MA.
Our success also depends on our ability to rapidly expand our website,
transaction-processing systems and network infrastructure without systems
interruptions in order to accommodate significant increases in customer traffic
and demand. Many of our software systems are custom-developed, and we rely on
our employees and third-party contractors to develop and maintain these systems.
If any of these employees or contractors become unavailable to us, we may
experience difficulty in improving and maintaining such systems.
In addition, we rely on a third party, Exodus Communications, to host our
website and are thus subject to its ability to provide service when and as we
require.
IF WE DO NOT RESPOND TO RAPID TECHNOLOGICAL CHANGES, OUR SERVICES COULD BECOME
OBSOLETE AND WE COULD LOSE CUSTOMERS.
To remain competitive, we must continue to enhance and improve the
functionality and features of our online store. The Internet and the online
commerce industry are rapidly changing. If competitors introduce new products
and services embodying new technologies or if new industry standards and
practices emerge, our existing website and proprietary technology and systems
may become obsolete. Our future success will depend on our ability to do the
following:
. both license and internally develop leading technologies useful in our
business
. enhance our existing services
. develop new services and technologies that address the increasingly
sophisticated and varied needs of our prospective customers
. respond to technological advances and emerging industry standards and
practices on a cost-effective and timely basis
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Ongoing development of our website and other proprietary technology entails
significant expense and technical risks. We may use new technologies
ineffectively or we may fail to adapt our website, transaction-processing
systems and network infrastructure to customer requirements or emerging industry
standards. If we face material delays in introducing new services, products and
enhancements, our customers may forego the use of our services and use those of
our competitors.
OUR FACILITIES AND SYSTEMS ARE VULNERABLE TO UNEXPECTED PROBLEMS INCLUDING
PROBLEMS RELATING TO SYSTEM EXPANSION ACTIVITIES OR LACK OF SYSTEM CAPACITY. THE
OCCURRENCE OF A NATURAL DISASTER OR OTHER UNEXPECTED PROBLEM COULD DAMAGE OUR
REPUTATION AND BRAND AND REDUCE OUR REVENUES.
Although we expect to periodically enhance and expand our website,
transaction-processing systems and network infrastructure, we may experience
interruptions in our systems. We may be unable to project the rate or timing of
increases, if any, in the use of our website. This would make it difficult for
us to effectively upgrade and expand our transaction-processing systems and to
smoothly integrate any newly developed or purchased modules with our existing
systems. To the extent we are required to outsource any technological
enhancements or become dependent on third party proprietary technology,
expanding and upgrading our systems could become more difficult. Due to the
seasonal nature of our business, it is particularly important that we are able
to expand our website, transaction-processing systems and network infrastructure
as necessary in preparation for the holiday season and that we operate during
that period without systems interruptions. Our failure to achieve or maintain
high capacity data transmission without system downtime, particularly during
this period, would adversely affect our business.
Substantially all of our computer and communications hardware systems related
to transaction processing and network infrastructure are hosted at a third-party
facility owned and operated by Exodus Communications in Waltham, Massachusetts.
Our systems and operations, including our fulfillment operation, at our new
distribution center in Mansfield, Massachusetts, are vulnerable to damage or
interruption from fire, flood, power loss, telecommunications failure, break-
ins, earthquake and similar events. Furthermore, our servers may be vulnerable
to computer viruses, physical or electronic break-ins and similar disruptions.
We have no formal disaster recovery plan, and our business interruption
insurance may not adequately compensate us for losses that may occur. The
occurrence of a natural disaster or unanticipated problems our new distribution
center or at the Exodus Communications facility could cause interruptions or
delays in our business, loss of data or render us unable to accept and fulfill
customer orders. The occurrence of any or all of these events could adversely
affect our reputation, brand and business.
THE SUCCESS OF OUR BUSINESS DEPENDS ON THE CONTINUING CONTRIBUTION OF OUR KEY
PERSONNEL, INCLUDING MR. DAVID A. BLOHM, OUR PRESIDENT AND CHIEF EXECUTIVE
OFFICER.
Our future success is dependent on key members of our management team and in
particular David A. Blohm, our President and Chief Executive Officer.
The competition for qualified personnel in the electronic commerce market is
extremely intense, especially in the Northeastern part of the United States.
The loss of service of Mr. Blohm or a significant number of our employees could
have a material adverse effect on our business. In particular, the loss of
several key programmers could inhibit the development and enhancement of our
website and could damage customer relations and our brand. Similarly, the loss
of several marketing and sales personnel could inhibit our ability to
effectively promote our website.
WE MAY BE SUBJECT TO PRODUCT LIABILITY CLAIMS.
We face an inherent risk of exposure to product liability claims in the event
that the use of the products we sell results in injury. We may not have adequate
resources in the event of a successful claim against us. Our general liability
insurance may not cover these claims or we may not be indemnified for any or all
of the liabilities that may be imposed. We cannot predict whether product
liability claims will be brought against us in the future or if the resulting
adverse publicity would harm our business.
WE DEPEND ON THE INTERNET AND THE DEVELOPMENT OF THE INTERNET INFRASTRUCTURE.
Our success will depend in large part on continued growth in, and the use of,
the Internet for commerce. The electronic commerce market is new and rapidly
evolving, and the extent of consumer acceptance is uncertain.
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The issues concerning the commercial use of the Internet that we expect to
affect the development of the market for our services include security,
reliability, cost of access, ease of access, ease of use, speed and quality of
service.
In addition, popular companies that provide access to Internet transactions
through network access or web browsers, such as America Online, Yahoo, Lycos and
Microsoft, could promote our competitors or charge us a substantial fee for
connection to our website. Either of these developments could adversely affect
our business.
OUR BUSINESS IS SUBJECT TO GOVERNMENT REGULATION OF THE INTERNET AND OTHER LEGAL
UNCERTAINTIES WHICH COULD NEGATIVELY IMPACT OUR OPERATIONS.
Law and regulations directly applicable to communications or commerce over the
Internet are becoming more prevalent. The U.S. Congress recently enacted
Internet laws, including laws relating to children's privacy, the transmission
of sexually explicit material and taxation of Internet-based enterprises.
As directed by Congress in the Children's Online Privacy Protection Act, the
Federal Trade Commission (the "FTC") recently adopted regulations that became
effective on April 21, 2000, prohibiting unfair and deceptive acts and practices
in connection with the collection and use of personal information from children
under 13 years old on the Internet.
There can be no assurance that we will adopt policies that conform to
regulations adopted or policies advocated by the FTC or any other governmental
entity. In addition, the FTC has already begun investigations into the privacy
practices of companies that collect information on the Internet. One
investigation resulted in a consent decree pursuant to which an Internet company
agreed to establish programs to implement the principles noted above. We may
become subject to a similar investigation, or the FTC's regulatory and
enforcement efforts may adversely affect our ability to collect demographic and
personal information from users, which could adversely affect our marketing
efforts.
In addition, the European Union recently enacted its own privacy regulations.
The European Union Directive on the Protection of Personal Data (the "EU
Directive"), which became effective in October 1998, fosters electronic commerce
by establishing a stable framework to ensure both a high level of protection for
private individuals and the free movement of personal data within the European
Union. The European Union and the U.S. Department of Commerce are currently
negotiating an agreement under which the privacy policies of U.S. businesses may
be deemed to be adequate under the EU Directive. Until such time as an agreement
is reached, the European Union has voluntarily agreed to a moratorium on
enforcement of the EU Directive against U.S. businesses. Although the Company
has received 3% of revenues from outside of the United States in the nine months
ended September 30, 2000, the European legislation and its adoption via any
agreement could adversely affect our ability to expand our sales efforts to
Europe by limiting how information about us can be sent over the Internet in the
EU and limiting our efforts to collect information from European users.
The U.S. Omnibus Appropriations Act of 1998 places a moratorium on taxes
levied on Internet access from October 1, 1998 to October 21, 2001. However,
states may place taxes on Internet access if taxes had already been generally
imposed and actually enforced prior to October 1, 1998. States which can show
they enforced Internet access taxes prior to October 1, 1998 and states after
October 21, 2001 may be able to levy taxes on Internet access resulting in
increased cost to access to the Internet, resulting in a material adverse effect
on our business.
The laws governing the use of the Internet, in general, remain largely
unsettled, even in areas where there has been some legislative action. It may
take years to determine whether and how existing laws such as those governing
intellectual property, privacy, libel and taxation apply to the Internet. In
addition, the growth and development of the market for online commerce may
prompt calls for more stringent consumer protection laws, both in the United
States and abroad. This occurrence may impose additional burdens on companies
conducting business online by limiting how information can flow over the
Internet and the type of information that can flow over the Internet. The
adoption or modification of laws or regulations relating to the Internet could
adversely affect our business. Because we receive a significant amount of orders
as a result of e-mail advertising, new regulations affecting the use of
unsolicited e-mail advertising would impair our marketing efforts.
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WE MAY BE LIABLE FOR THE CONTENT WE PROVIDE ON OUR WEBSITE OR WHICH IS ACCESSED
FROM OUR WEBSITE.
We believe that our future success will depend in part upon our ability to
deliver original and compelling descriptive content about the children's
educational books, toys and games, and software that we sell on the Internet.
As a publisher of online content, we face potential liability for defamation,
negligence, copyright, patent or trademark infringement, or other claims based
on the nature and content of materials that we publish or distribute. In the
past, plaintiffs have brought such claims and sometimes successfully litigated
them against online services. Although we carry general liability insurance, our
insurance may not cover claims of these types or may be inadequate to indemnify
us for all liability that may be imposed on us. If we face liability,
particularly liability that is not covered by our insurance or is in excess of
our insurance coverage, then our reputation and our business may suffer.
OUR REVENUES AND REPUTATION WOULD BE ADVERSELY AFFECTED IF OUR SECURITY MEASURES
FAIL.
Consumer concerns regarding the security of transactions conducted on the
Internet and users' privacy may inhibit the growth of use of the Internet and
electronic commerce. To securely transmit confidential information, such as
customer credit card numbers, we rely on encryption and authentication
technology that we license from third parties. We cannot predict whether we will
experience compromises of, or breaches in, the technologies we use to protect
customer transaction data.
We may need to expend significant additional capital and other resources to
protect against security breaches or alleviate problems caused by any such
breaches. We cannot guarantee that security breaches will not occur, and if our
security measures fail, our business could be harmed. Any penetration of our
network security or misappropriation of our users' personal or credit card
information could subject us to liability. Claims could also be based on other
misuses of personal information, including the use of this information for
unauthorized marketing purposes. These claims could result in litigation.
OUR REVENUES AND REPUTATION WOULD BE ADVERSELY AFFECTED IF WE EXPERIENCE
SIGNIFICANT CREDIT CARD FRAUD.
Under current credit card practices, merchants are liable for fraudulent
credit card transactions where, as is the case with the transactions we process,
the merchant does not obtain a cardholder's signature. We may be liable for
claims based on unauthorized purchases with credit card information,
impersonation or other similar fraud claims. A failure to adequately control
fraudulent credit card transactions would harm our business.
PRIVACY CONCERNS AND LEGISLATION MAY LIMIT THE INFORMATION WE CAN GATHER.
When a visitor first arrives at our website, our software creates a profile
for that visitor. If the visitor registers or logs in, the visitor's identity is
added to the profile, preserving any profile information that was gathered up to
that point. We track both explicit user profile data supplied by the user, as
well as implicit profile attributes derived from the user's behavior on the
website. We also suggest that parents provide us with an educational profile on
their children, an important feature of our website. Privacy concerns relating
to children are particularly acute. Privacy concerns may cause visitors to
resist providing the personal data or avoid websites that track the behavioral
information necessary to support this profiling capability. More importantly,
even the perception of security and privacy concerns, whether or not valid, may
indirectly inhibit market acceptance of our products. For example, the European
Union recently adopted a directive addressing data privacy that may limit the
collection and use of certain information regarding Internet users. This
directive may limit our ability to target advertising or collect and use
information in certain European countries. In addition, legislative or
regulatory requirements may heighten these concerns if businesses must notify
website users that the data captured after visiting websites may be used to
direct product promotion and advertising to that user. Other countries and
political entities, such as the European Union, have adopted such legislation or
regulatory requirements. The United States may adopt similar legislation or
regulatory requirements. If privacy legislation is enacted or consumer privacy
concerns are not adequately addressed, our business, financial condition and
operating results could be harmed.
Websites typically place "cookies" on a user's hard drive without the user's
knowledge or consent. We use cookies for a variety of reasons, including the
collection of data derived from the user's Internet activity. Most currently
available web browsers allow users to remove cookies at any time or to prevent
cookies from being stored on their hard drives. In addition, some commentators,
privacy advocates and governmental bodies have suggested limiting or eliminating
the use of cookies. Any reduction or limitation in the use of cookies could
limit the
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effectiveness of our sales and marketing efforts. The FTC and several states
have investigated the use by certain Internet companies of personal information.
We could incur significant additional expenses if new regulations regarding the
use of personal information are introduced or if our privacy practices are
investigated.
OUR REVENUES COULD DECREASE IF WE BECAME SUBJECT TO SALES AND OTHER TAXES.
We do not currently collect sales or other similar taxes for physical
shipments of goods into states other than Massachusetts. However, one or more
local, state, federal or foreign jurisdictions may seek to impose sales tax
collection obligations on us. In addition, any new operation in states outside
Massachusetts could subject our shipments in such states to state sales taxes
under current or future laws. A number of legislative proposals have been made
at the federal, state and local level and by foreign governments that would
impose additional taxes on the sale of goods and services over the Internet and
certain states have taken measures to tax Internet-related activities. Although
Congress recently placed a three-year moratorium on new state and local taxes on
Internet access or on discriminatory taxes on electronic commerce, existing
state or local laws were expressly excepted from this moratorium. Further, once
this moratorium expires, some type of federal and/or state taxes may be imposed
upon Internet commerce. The moratorium is presently scheduled to expire on
October 20, 2001. Such legislation or other attempts at regulating commerce over
the Internet may substantially impair the growth of commerce on the Internet
and, as a result, adversely affect our opportunity to derive financial benefit
from such activities. If one or more states or any foreign country successfully
asserts that we should collect sales or other taxes on the sale of our products,
it could adversely affect our business and results of operations.
SMARTERKIDS.COM'S STOCK PRICE, LIKE THAT OF OTHER RETAIL E-COMMERCE COMPANIES,
IS SUBJECT TO SIGNIFICANT VOLATILITY WHICH COULD RESULT IN SUBSTANTIAL LOSSES
FOR INDIVIDUAL SECURITY HOLDERS.
Our stock price has been and is likely to continue to be highly volatile
because of the following factors, some of which are beyond our control:
. speculation in the press or investment community
. changes in revenue or earnings estimates by the investment community
. announcement of new competitors in a highly competitive marketplace
. changes in the economic performance and/or market valuations of other
internet, online commerce or retail companies
. volatility in the stock markets, particularly with respect to internet
stocks, and decreases in the availability of capital for Internet-related
businesses
In addition, Smarterkids.com's stock price may be affected by general market
conditions and economic factors unrelated to Smarterkids.com's performance.
From November 23, 1999 (the first day of public trading of our common stock),
through November 13, 2000, the high and low sales prices of our common stock
fluctuated between $17.13 and $1.03. On November 13, 2000, the closing price of
our common stock was $1.91. In the past, following periods of volatility in the
market price of their securities, many companies have been the subject of
securities class action litigation. If we were sued in a securities class
action, it could result in substantial costs and a diversion of management's
attention and resources and would cause the prices of our common stock to fall.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The following discussion about the Company's market risk includes "forward-
looking statements" that involve risks and uncertainties. Actual results could
differ materially from those projected in the forward-looking statements.
The Company does not use derivative financial instruments for speculative or
trading purposes.
Interest Rate Risk. SmarterKids.com is exposed to market risk from changes in
interest rates primarily through its investing activities. In addition, our
ability to finance future acquisition transactions may be impacted if we are
unable to obtain appropriate financing at acceptable rates. Our investment
portfolio consists solely of investments in high-grade, commercial bank money
market accounts and certificates of deposit.
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Credit Risk. Financial instruments which potentially subject the Company to
concentrations of credit risk consist primarily of cash, cash equivalents,
short-term investments and accounts receivable. The Company does not believe
that it is subject to any unusual credit risk beyond the normal credit risk
associated with commercial banking relationships.
PART II: OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
(c) Recent Sales of Unregistered Securities
In connection with the equipment line credit facility entered into in April 13,
2000, the Company issued to TLP Leasing Programs, Inc. 16,667 warrants for
Company common stock at an exercise price of $3.00 per share and an aggregate
exercise price of $50,001. Upon the exercise of the warrants, which may take
place at any time before the expiration of warrants of April 13, 2006, each
warrant shall convert into one share of the Company's common stock, par value
.01 per share. The Company claims that the offer and sale of the Shares were
exempt from registration under the Securities Act of 1933, as amended, pursuant
to Rule 506 of Regulation D. The warrants were offered only to TLP Leasing
Programs, Inc., an "Accredited Investor" as such term is defined in Rule 501 of
Regulation D.
During the nine months ended September 30, 2000, there have been no changes with
respect to the Company's common stock. We received capital from investors in
three private venture capital financings totaling $37.0 million through July
1999.
(d) Use of Proceeds from Registered Securities
On November 23, 1999, the Company completed an initial public offering of
4,500,000 shares of common stock $0.01 par value per share (5,175,000 shares
including 658,500 over-allotment shares and 16,500 shares offered by selling
stockholders), resulting in net proceeds to the Company of $65.9 million. The
primary purposes of the initial public offering were to increase our
capitalization and financial flexibility, create a public market for
SmarterKids.com's common stock, and facilitate future access to public markets.
As of September 30, 2000, SmarterKids.com used $32.9 million of the offering
proceeds for working capital and approximately $33.0 million of the offering
proceeds remain in cash and short-term investments.
ITEM 5. OTHER INFORMATION
In September 2000, each of Bob Cahill, Richard Viard, Richard Secor, Lisa
Tanzer, Dan Davis, Mark DeChambeau, Al Noyes, Joe Panepinto, Evelyn Somers, and
John Zimmerman (each an "Executive") and the Company executed a Change of
Control Agreement pursuant to which, if the Executive is terminated by the
Company as a result of a change of control (as defined in the Change of Control
Agreement) within three years from the date of such agreement, the Company would
(i) pay the Executive's base salary until the earlier of (a) six months, or
(b) the date the Executive is employed by a subsequent employer or is engaged as
a consultant; (ii) pay the Executive's monthly premium for continued medical and
dental insurance coverage if the Executive elects to continue such coverage
under the Consolidated Omnibus Budget Reconciliation Act of 1985 ("COBRA") until
the earlier of (a) six months or (b) the date the Executive's COBRA coverage
would terminate in accordance with the provisions of COBRA, and (iii) accelerate
the vesting of such Executive's incentive and non-qualified options by six
months.
In September 2000, each of David Blohm and Jeff Pucci (each a "Senior
Executive") and the Company executed a Change of Control Agreement pursuant to
which, if the Senior Executive is terminated by the Company as a result of a
change of control (as defined in the Change of Control Agreement) within three
years from the date of such agreement, the Company would (i) pay the Senior
Executive's base salary until the earlier of (a) 12 months, or (b) the date the
Senior Executive is employed by a subsequent employer or is engaged as a
consultant; (ii) pay the Senior Executive's monthly premium for continued
medical and dental insurance coverage if the Senior Executive elects to continue
such coverage under COBRA until the earlier of (a) 12 months or (b) the date the
Senior Executive's COBRA coverage would terminate in
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accordance with the provisions of COBRA, and (iii) accelerate the vesting of
such Senior Executive officers incentive and non-qualified options by 12 months.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) EXHIBITS
EXHIBIT NO. Exhibit
----------- -------
10.1 Form of Change of Control for Executive Officers
10.2 Form of Change of Control for Senior Executive Officers
27.1 Financial Data Schedule (This exhibit has been omitted
because the information is shown in the financial
statements or notes thereto.)
(b) REPORTS ON FORM 8-K.
Not applicable.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, as amended, the Registrant has duly caused this report to be signed
on its behalf by the undersigned thereunto duly authorized.
SMARTERKIDS.COM, INC.
(Registrant)
Date: November 14, 2000 By: /s/ Robert J. Cahill
-------------------------------
Robert J. Cahill
Chief Financial Officer
(Duly Authorized Officer and
Principal Financial and
Accounting Officer)
<PAGE>
Exhibit Index
10.1 Form of Change of Control Agreement for
Executive Officers
10.2 Form of Change of Control Agreement for
Senior Executive Officers
27.1 Financial Data Schedule
