<PAGE>
FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: March 27, 1999 Commission file No. 0-15338
-------------- -------
SEATTLE FILMWORKS, 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
--- ---
As of April 30, 1999, there were issued and outstanding 16,301,435
shares of common stock, par value $.01 per share.
Index to Exhibits at Page 17
Page 1 of 18
<PAGE>
SEATTLE FILMWORKS, INC.
INDEX
-----
Page No.
--------
PART I -- FINANCIAL INFORMATION
<TABLE>
<CAPTION>
<S> <C>
Item 1 - Financial Statements 3-8
Consolidated Balance Sheets as of March 27, 1999
and September 26, 1998 3-4
Consolidated Statements of Operations for the second quarter
and six months ended March 27, 1999 and March 28, 1998 5
Consolidated Statements of Cash Flows for the six months
ended March 27, 1999 and March 28, 1998 6
Notes to Consolidated Financial Statements 7-8
Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations 9-14
PART II -- OTHER INFORMATION
Item 1 - Legal Proceedings 15
Item 4 - Submission of Matters to a Vote of Security Holders 15
Item 6 - Exhibits and Reports on Form 8-K 15
SIGNATURES 16
INDEX TO EXHIBITS 17
EXHIBITS 18
</TABLE>
Page 2 of 18
<PAGE>
PART I -- FINANCIAL INFORMATION
-------------------------------
ITEM 1 - FINANCIAL STATEMENTS
SEATTLE FILMWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
<TABLE>
<CAPTION>
(UNAUDITED) (NOTE)
March 27, September 26,
ASSETS 1999 1998
=================================================================================================
<S> <C> <C>
CURRENT ASSETS
Cash and cash equivalents $12,188 $11,780
Securities available-for-sale 3,848 4,555
Accounts receivable, net of allowance for doubtful accounts 1,037 1,914
Inventories 9,995 7,561
Capitalized promotional expenditures 165 121
Prepaid expenses and other 1,596 831
Deferred income taxes 358 387
------- -------
TOTAL CURRENT ASSETS 29,187 27,149
FURNITURE, FIXTURES, AND EQUIPMENT,
at cost, less accumulated depreciation 11,087 10,954
CAPITALIZED CUSTOMER ACQUISITION EXPENDITURES 8,400 16,800
DEPOSITS AND OTHER ASSETS 590 213
------- -------
TOTAL ASSETS $49,264 $55,116
======= =======
</TABLE>
Note: The September 26, 1998 consolidated balance sheet has been derived from
audited consolidated financial statements.
See notes to consolidated financial statements.
Page 3 of 18
<PAGE>
SEATTLE FILMWORKS, INC.
CONSOLIDATED BALANCE SHEETS (continued)
(in thousands, except per share and share data)
<TABLE>
<CAPTION>
(UNAUDITED) (NOTE)
March 27, September 26,
LIABILITIES AND SHAREHOLDERS' EQUITY 1999 1998
===============================================================================================
<S> <C> <C>
CURRENT LIABILITIES
Accounts payable $ 4,918 $ 2,359
Current portion of capital lease obligations 179 174
Accrued expenses 1,187 1,376
Accrued compensation 1,514 1,570
Income taxes payable 7 7
------- -------
TOTAL CURRENT LIABILITIES 7,805 5,486
LONG-TERM CAPITAL LEASE OBLIGATIONS, net of current portion 631 706
DEFERRED INCOME TAXES 2,096 5,223
------- -------
TOTAL LIABILITIES 10,532 11,415
SHAREHOLDERS' EQUITY
Preferred Stock, $.01 par value,
authorized 2,000,000 shares, none issued
Common Stock, $.01 par value, authorized 101,250,000
shares, issued and outstanding 16,266,986 163 167
Additional paid-in capital 23 981
Retained earnings 38,546 42,553
------- -------
TOTAL SHAREHOLDERS' EQUITY 38,732 43,701
------- -------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $49,264 $55,116
======= =======
</TABLE>
Note: The September 26, 1998 consolidated balance sheet has been derived from
audited consolidated financial statements.
See notes to consolidated financial statements.
Page 4 of 18
<PAGE>
SEATTLE FILMWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(in thousands, except per share and share data)
<TABLE>
<CAPTION>
Second Quarter Ended Six Months Ended
----------------------- -----------------------
March 27, March 28, March 27, March 28,
1999 1998 1999 1998
========== ========== ========== ==========
<S> <C> <C> <C> <C>
Net revenues $19,302 $21,439 $40,814 $43,910
Cost of goods and services 12,750 12,408 26,557 25,380
------- ------- ------- -------
GROSS PROFIT 6,552 9,031 14,257 18,530
Operating expenses:
Amortized customer acquisition costs 4,200 3,944 8,400 7,772
Marketing expenses 5,208 2,263 9,386 4,578
Research and development 287 153 455 296
General and administrative 1,216 1,043 2,360 2,099
------- ------- ------- -------
Total operating expenses 10,911 7,403 20,601 14,745
------- ------- ------- -------
INCOME (LOSS) FROM OPERATIONS (4,359) 1,628 (6,344) 3,785
Other income (expense):
Interest income 188 175 420 389
Non-operating expense, net (54) (12) (54) (12)
------- ------- ------- -------
Total other income 134 163 366 377
------- ------- ------- -------
INCOME (LOSS) BEFORE INCOME TAXES (4,225) 1,791 (5,978) 4,162
Benefit (Provision) for income taxes 1,692 (614) 2,393 (1,427)
------- ------- ------- -------
NET INCOME (LOSS) $(2,533) $ 1,177 $(3,585) $ 2,735
======= ======= ======= =======
Diluted Earnings (Loss) per Share $ (.16) $ .07 $ (.22) $ .16
======= ======= ======= =======
Basic Earnings (Loss) per Share $ (.16) $ .07 $ (.22) $ .17
======= ======= ======= =======
Weighted Average Shares and Dilutive
Equivalents Outstanding 16,257,000 17,479,000 16,297,000 17,561,000
========== ========== ========== ==========
Weighted Average Shares - Basic 16,257,000 16,564,000 16,297,000 16,552,000
========== ========== ========== ==========
</TABLE>
See notes to consolidated financial statements.
Page 5 of 18
<PAGE>
SEATTLE FILMWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(in thousands)
<TABLE>
<CAPTION>
Six Months Ended
-----------------------
March 27, March 28,
1999 1998
========== ==========
<S> <C> <C>
OPERATING ACTIVITIES:
- --------------------
Net income (loss) $(3,585) $ 2,735
Charges to income not affecting cash:
Depreciation and amortization 2,317 1,885
Amortization of capitalized customer
acquisition expenditures 8,400 7,772
Deferred income taxes (3,098) 772
Net change in receivables, inventories, payables and other (9) (1,818)
Capitalized promotional expenditures, net (44) 95
Additions to capitalized customer acquisition expenditures - (10,294)
------- --------
NET CASH FROM OPERATING ACTIVITIES 3,981 1,147
INVESTING ACTIVITIES:
- --------------------
Purchase of furniture, fixtures, and equipment (2,826) (2,808)
Purchases of securities available-for-sale (1,236) (3,620)
Sales of securities available-for-sale 1,943 3,437
------- --------
NET CASH USED IN INVESTING ACTIVITIES (2,119) (2,991)
FINANCING ACTIVITIES:
- --------------------
Proceeds from issuance of Common Stock 109 706
Payment on purchase of Common Stock (1,493) (2,637)
Payment on capital lease obligation (70) -
------- --------
NET CASH USED IN FINANCING ACTIVITIES (1,454) (1,931)
------- --------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 408 (3,775)
Cash and cash equivalents at beginning of period 11,780 10,252
------- --------
CASH AND CASH EQUIVALENTS
AT END OF PERIOD $12,188 $ 6,477
======= ========
</TABLE>
See notes to consolidated financial statements.
Page 6 of 18
<PAGE>
SEATTLE FILMWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE A -- BASIS OF PRESENTATION
Seattle FilmWorks, Inc. and its subsidiaries (the "Company") is a leading
direct-to-consumer marketer and provider of high-quality amateur traditional
photofinishing and digital and Internet related imaging services and products.
The Company offers an array of complementary services and products, primarily on
a mail-order basis, under the brand name Seattle FilmWorks(R). To a lesser
extent, the Company provides services, products and photofinishing supplies on a
wholesale basis to a variety of commercial customers.
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 generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring adjustments) considered necessary for fair presentation of
interim results have been included. The Company follows a policy of recording
its interim periods and year-end on a 5 week, 4 week and 4 week basis for
comparability of results and to be consistent with its internal weekly
reporting. Operating results for the second quarter and six months ended March
27, 1999 are not necessarily indicative of the results that may be expected for
the fiscal year ending September 25, 1999. For further information, refer to
the "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and consolidated financial statements and footnotes thereto included
in the Company's Annual Report on Form 10-K for the year ended September 26,
1998.
NOTE B -- CUSTOMER ACQUISITION EXPENDITURES
The Company's principal technique for acquiring new customers is its
Introductory Offer of two rolls of 35mm film for $2.00 or less. Customer
acquisition costs are comprised of the costs of generating a lead and the
amortization of direct costs associated with the Company's promotional offers
sent to prospective and existing customers. The costs of generating a lead,
which are expensed when the promotion is run, include all direct-response media,
advertising and other costs associated with developing target customer lists.
The direct costs of customer acquisition include film, postage and printed
material costs associated with mailings to prospective and existing customers.
Prior to fiscal 1999, the direct costs of customer acquisition were capitalized
as an asset on the Company's consolidated balance sheet under "capitalized
customer acquisition expenditures" and those related to prospective customers
were amortized over three years on an accelerated basis.
During the fourth quarter of fiscal 1998 the overall performance of the
customer acquisition programs showed a decline. Upon completing the quarterly
review of the recoverability of the capitalized costs as of September 26, 1998,
management concluded that the lower response rates to customer acquisition
programs required an adjustment to the amount of capitalized costs associated
with those programs. Accordingly, the Company reduced the capitalized customer
acquisition cost asset by $613,000 to its net realizable value. In accounting
for customer acquisition costs, the Company follows the American Institute of
Certified Public Accountants Statement of Position 93-7, Reporting on
Advertising Costs (SOP 93-7). Previously, the Company capitalized and then
amortized customer acquisition costs so that the expenses resulting from the
amortization of these costs would match the period in which associated estimated
revenue would be received with respect to those marketing efforts. However, as
a result of recent trends in customer responses, the Company's marketing plans
and Internet and retail distribution strategies, management believes that the
net profit margin on identifiable responses will be insufficient to justify
deferral of such costs in the future. Effective in the first quarter of fiscal
1999, the Company began expensing all customer acquisition costs as incurred.
In addition, the Company began amortizing $16,800,000 of previously deferred
customer acquisition costs over a twelve month period on a straight-line basis.
In the first six months of fiscal 1999, the change in estimate from a three year
accelerated amortization to a twelve month straight-line amortization resulted
in incremental amortization of previously deferred customer acquisition costs of
$1,815,000 or a loss of $.07 per share.
NOTE C -- RECLASSIFICATIONS
Certain prior year balances have been reclassified to conform to the
current year's presentation.
Page 7 of 18
<PAGE>
SEATTLE FILMWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE D -- CONTINGENCIES
The Company is a defendant in a legal proceeding that was filed by Fuji
Photo Film Co., Ltd. ("Fuji") with the International Trade Commission ("ITC") on
February 13, 1998. The action was filed against a number of importers,
including the Company's OptiColor, Inc. subsidiary, alleging patent infringement
of U.S. patents on single use cameras through the importation and resale of
recycled cameras. Fuji is seeking an order prohibiting importation of
infringing cameras into the U.S. and prohibiting further sales of such products
which have been imported. Sales of recycled cameras accounted for 3.8% of the
Company's net revenues during fiscal 1998 and 4.4% during the first six months
of fiscal 1999. An evidentiary hearing before an ITC Administrative Law Judge
("ALJ") was held in November, 1998 and the ALJ has issued an initial decision in
favor of Fuji which the ITC Commissioners have decided to let stand. The ITC
Commissioners are expected to issue a final order in late May or early June,
1999; it is likely that the order will prohibit the Company and its subsidiaries
from importing and selling imported recycled single use cameras. The ITC
Commissioners' order will be subject to appeal to the Federal Circuit Court of
Appeals. The Company is currently considering whether to appeal the ITC order.
There is risk that Fuji might bring a civil action against OptiColor and the
Company for damages for patent infringement by reason of sales of cameras which
have been found in the ITC proceeding to infringe Fuji patents. If such an
action were brought, the ITC decision would not be binding in the civil
proceeding and would not prevent OptiColor and the Company from raising and
litigating all available defenses. At this time, the likelihood that such an
action would be brought, and, if brought, its ultimate outcome and impact on the
Company, are not determinable. The Company does not expect the pending
litigation to have a significant impact on its financial condition, results of
operations or liquidity. The Company is also involved in various routine legal
proceedings in the ordinary course of its business.
NOTE E -- EARNINGS PER SHARE
The Company calculates earnings per share in accordance with the SFAS No.
128, "Earnings per Share". Earnings per share is based on the weighted average
number of shares and dilutive Common Stock equivalents outstanding during the
period. Common Stock equivalents consist of stock options. The dilutive effect
of stock options, if any, is excluded from the calculation of basic earnings per
share, but included in the computation of diluted earnings per share.
The following table sets forth the computation of basic and diluted
earnings per share:
<TABLE>
<CAPTION>
Second Quarter Ended Six Months Ended
-------------------------------- ----------------
March 27, 1999 March 28, 1998 March 27, 1999 March 28, 1998
=============== ============== ================= ==============
<S> <C> <C> <C> <C>
Numerator for basic and diluted earnings per share:
Net income (loss) $(2,533,000) $ 1,177,000 $(3,585,000) $ 2,735,000
=========== =========== =========== ===========
Denominator:
Denominator for basic earnings per share -
weighted-average shares 16,257,000 16,564,000 16,297,000 16,552,000
Net effect of dilutive stock options - 915,000 - 1,009,000
----------- ----------- ----------- -----------
Denominator for diluted earnings per share 16,257,000 17,479,000 16,297,000 17,561,000
=========== =========== =========== ===========
Basic Earnings (Loss) per Share $ (.16) $ .07 $ (.22) $ .17
=========== =========== =========== ===========
Diluted Earnings (Loss) per Share $ (.16) $ .07 $ (.22) $ .16
=========== =========== =========== ===========
</TABLE>
NOTE F -- SEGMENT REPORTING
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) No. 131, "Disclosure about Segments of an
Enterprise and Related Information." SFAS No. 131, which is effective for years
beginning after December 15, 1997, establishes standards for the way that public
business enterprises report information about operating segments in published
financial reports. The Company will adopt the new requirements in fiscal 1999.
Management has not yet determined the manner in which it will present the
information required by SFAS No. 131.
Page 8 of 18
<PAGE>
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Forward-Looking Information
- ---------------------------
Statements in this report concerning future results, trends, new product or
service development or introduction plans, digital image storage capacity and
durability, Year 2000 or any other statement which may be construed as a
prediction of future capabilities, performance or events are forward-looking
statements, the occurrence of which are subject to a number of known and unknown
risks and uncertainties which might cause actual capabilities, performance, or
occurrences to differ materially from those expressed or implied by such
statements. These risks and uncertainties include the Company's ability to
create and implement effective customer acquisition techniques; timely
development, delivery and market acceptance of products and services which
differentiate the Company from other photofinishers; technological changes;
product development or production difficulties or delays due to technical
difficulties, supply constraints or other factors; changing economic conditions;
the impact of competitive products and pricing; the possibility of delays in the
expansion of image storage capacity due to delays in deliveries from suppliers
or technical problems; system performance problems due to malfunctions, Internet
interruptions or other factors; and other risks including those described in the
Company's Annual Report on Form 10-K and those described from time to time 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
- -------
Seattle FilmWorks, Inc. including its subsidiaries is a leading direct-to-
consumer marketer and provider of high-quality amateur traditional
photofinishing and digital and Internet imaging services and products. The
Company offers an array of complementary services and products primarily on a
mail-order basis under the brand name Seattle FilmWorks(R). To promote its
service and products, the Company relies primarily on direct-marketing programs,
including the customer acquisition technique of offering two rolls of film for
$2.00 or less (the "Introductory Offer"). The Introductory Offer has been
nationally advertised in package inserts, newspaper supplements and magazines
and through various other direct-response media. Beginning in fiscal 1995, the
Company shifted the focus of, and substantially expanded, its customer
acquisition programs. This shift in focus included mailing of two rolls of film
to users of personal computers, together with materials promoting the Company's
digital imaging services and products, such as Pictures On Disk(TM) and
PhotoMail(TM) Internet image delivery.
Customer acquisition costs are comprised of the costs of generating a lead
and the amortization of direct costs associated with the Company's promotional
offers sent to prospective and existing customers. The costs of generating a
lead include all direct-response media, advertising and other costs associated
with developing target customer lists. The direct costs of customer acquisition
include film, postage and printed material costs associated with mailings to
prospective and existing customers.
Until the end of fiscal 1998, the direct costs of customer acquisition were
capitalized as an asset on the Company's consolidated balance sheet as
"capitalized customer acquisition expenditures." Historically, capitalized
customer acquisition expenditures relating to prospective customers were
amortized over three years, and, beginning in fiscal 1996, capitalized customer
acquisition expenditures relating to certain marketing activities to groups of
existing customers were amortized over six months. These amortization rates
were based on estimates of the timing of future roll processing volumes per
customer. The proportion of capitalized customer acquisition expenditures
amortized over three years relative to those to be amortized over six months
varied from period to period based on the timing and mix of promotional
activities. Based on developments in fiscal 1998 as discussed below, the
Company has changed its accounting estimate for customer acquisition costs in
future periods.
For approximately 75% of rolls received from customers, the Company has the
ability to determine the specific mailing to which a customer is responding.
These "identifiable responses" serve as the basis for estimates of future
response rates for the purpose of determining the appropriate amortization
period and for the purpose of assessing recoverability of the investment in
customer acquisition expenditures. Net recoverability estimates of the
capitalized costs are assessed each quarter based on identifiable responses to
the programs for which costs are recorded as an asset. Specifically, the
Company compared amortized expense of customer acquisition programs with the
actual profitability of such programs to assess whether the costs are fully
recoverable. Quarterly analyses prior to fiscal 1998 indicated that the
marketing programs for
Page 9 of 18
<PAGE>
which costs were capitalized were consistently yielding net profits from
identifiable responses in excess of the program costs. During the first three
quarters of fiscal 1998, the quarterly analyses showed a decline in net
profitability, but capitalized costs appeared to be fully recoverable. As
discussed in the 10-Q filing for the third fiscal quarter ended June 27, 1998,
management's statistical analysis of marketing programs indicated that
photofinishing volumes continued to be adversely affected by extended delivery
times experienced by customers during the summer of 1997. Based on this analysis
completed in the third quarter of fiscal 1998, management believed that these
extended delivery times had a negative impact on customer responses.
Nevertheless, the amount of net capitalized costs at the end of the third
quarter of fiscal 1998 were not in excess of the estimated net profit from
identifiable responses expected to be received under the programs in the future.
During the fourth quarter of fiscal 1998 the overall performance of
customer acquisition programs continued to decline. Upon completing the
quarterly review of the recoverability of capitalized costs as of September 26,
1998, management concluded that the lower response rates to customer acquisition
programs required an adjustment to the amount of capitalized costs associated
with those programs. Accordingly, the Company reduced the capitalized customer
acquisition cost asset by $613,000, or 3.5% of the total asset of $17,400,000,
recognizing the $613,000 as a pre-tax expense in the fourth quarter of fiscal
1998 and reducing the capitalized customer acquisition cost asset to $16,800,000
as of September 26, 1998. Management attributes the need for this action to a
gradual decline in profitability of the average customer, primarily related to
response rates.
Through fiscal 1998, capitalized customer acquisition costs were amortized
over 36 months on an accelerated basis. Historical statistical data supported
this amortization schedule as a good approximation of identifiable responses to
specific customer acquisition marketing programs. As a result, this
amortization estimate provided a good matching of the amortization of
capitalized direct marketing costs with related revenue in accordance with the
American Institute of Certified Public Accountants ("AICPA") Statement of
Position 93-7, Accounting for Advertising Costs ("SOP 93-7"). Prior to fiscal
---------------------------------------------
1999 the Company had not sent repeat mailings of its introductory free film to
households which had received such a mailing within the last 36 months, because
to do so would have obscured the response rates to the initial mailing.
However, recent marketing tests show that repeat mailings may, in some cases, be
more productive than seeking out a marginal new target customer. Under current
marketing plans, which commenced in the first quarter of fiscal 1999, a
significant number of previously targeted and existing customers will receive
additional marketing mailings.
Given the negative trend in identifiable response rates to the Company's
marketing programs, management believed there was growing uncertainty about the
reliability of historical response rates to predict future performance of its
marketing programs. Management also believed significant costs remained
capitalized on the Company's balance sheet which related to prior marketing
activity to a number of individuals likely to receive additional marketing
mailings during fiscal 1999. In addition, industry trends suggest that direct
marketing with free film may have decreasing marginal returns. Digital
technologies are an emerging substitute to film-based systems and growing
acceptance of these technologies may cause further deterioration of results from
direct marketing programs as consumer behavior changes.
The Company is actively pursuing Internet and retail distribution as a
complement to its mail order business. It is more difficult to track direct
marketing program response rates in a retail environment because customers do
not generally submit their orders with coded response forms. As noted above, in
accounting for customer acquisition costs, the Company follows SOP 93-7.
Previously, the Company was required by SOP 93-7 to capitalize and then amortize
customer acquisition costs so that the expenses resulting from the amortization
of these costs would match the period in which associated estimated revenue
would be received from identifiable responses to those marketing efforts.
However, as a result of recent trends in customer responses, the Company's
marketing plans and Internet and retail distribution strategies, management
believes that the net profit margin on identifiable responses would not be
sufficient to justify deferral of such costs due to the trend of lower response
rates and to an expected decline in the percentage of identifiable responses to
individual programs. As a result of these changes in circumstances, management
no longer had persuasive evidence that future direct response advertising would
have identifiable results to the degree of reliability that would otherwise
require capitalization of such costs pursuant to SOP 93-7. As discussed in the
Company's fiscal 1998 Annual Report on Form 10-K, effective in the first quarter
of fiscal 1999, the Company began expensing all customer acquisition costs as
incurred. In addition, the Company began amortizing $16,800,000 of previously
deferred customer acquisition costs over a twelve month period on a straight-
line basis. During each of the first and second quarters of fiscal 1999, the
Company amortized $4,200,000 of previously capitalized customer acquisition
costs in addition to current period marketing costs. The Company expects to
amortize
Page 10 of 18
<PAGE>
$4,200,000 of the remaining capitalized customer acquisition expenditures in
each of the two remaining quarters of fiscal 1999. Accordingly, operating
expenses will be significantly higher in fiscal 1999 compared to prior periods.
Future periods may reflect increased or decreased customer acquisition costs due
to the expensing of such costs as incurred, as well as the timing and magnitude
of marketing activities.
Net loss for the first six months of fiscal 1999 was $3,585,000, or a loss
of $.22 per share, compared to net income of $2,735,000 or diluted earnings per
share of $.16 for the six months of fiscal 1998. The net loss in fiscal 1999 as
compared to net income in fiscal 1998 was primarily attributable to the increase
in operating costs as a result of the accelerated amortization of previously
deferred customer acquisition costs and expensing of current period marketing
costs combined with a decrease in gross profit. Operating results will
fluctuate in the future due to changes in the mix of sales, intensity and
effectiveness of promotional activities, price increases by suppliers,
introductions of new products, research and development requirements, actions by
competitors, foreign currency exchange rates, conditions in the direct-to-
consumer market and the photofinishing industry in general, national and global
economic conditions and other factors.
Demand for the Company's photo-related services and products is highly
seasonal, with the highest volume of photofinishing activity occurring during
the summer months. However, seasonality of demand may be offset by the
introduction of new services and products, changes in the level of effectiveness
of customer acquisition and marketing programs, activities by competitors,
production difficulties and other factors. This seasonality, when combined with
the general growth of the Company's photofinishing business, has produced
greater photofinishing net revenues during the last half of the Company's fiscal
year (April through September), with a peak occurring in the fourth fiscal
quarter. Net income is 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 the Company's practice of
incurring relatively higher marketing program expenditures prior to the summer
months.
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.
<TABLE>
<CAPTION>
Second Quarter Ended Six Months Ended
----------------------- -----------------------
March 27, March 28, March 27, March 28,
1999 1998 1999 1998
===============================================================================================
<S> <C> <C> <C> <C>
Net revenues 100.0% 100.0% 100.0% 100.0%
Cost of goods and services 66.1 57.9 65.1 57.8
------ ----- ----- -----
GROSS PROFIT 33.9 42.1 34.9 42.2
Operating expenses:
Amortized customer acquisition costs 21.7 18.4 20.6 17.7
Marketing expenses 27.0 10.6 23.0 10.4
Research and development 1.5 0.7 1.1 0.7
General and administrative 6.3 4.8 5.8 4.8
------ ----- ----- -----
Total operating expenses 56.5 34.5 50.5 33.6
------ ----- ----- -----
INCOME (LOSS) FROM OPERATIONS (22.6) 7.6 (15.6) 8.6
Total other income 0.7 0.8 0.9 0.8
------ ----- ----- -----
INCOME (LOSS) BEFORE INCOME TAXES (21.9) 8.4 (14.7) 9.4
Benefit (provision) for income taxes 8.8 (2.9) 5.9 (3.2)
------ ----- ----- -----
NET INCOME (LOSS) (13.1)% 5.5% (8.8)% 6.2%
====== ===== ===== =====
</TABLE>
Page 11 of 18
<PAGE>
Net revenues for the second quarter of fiscal 1999 were $19,302,000
compared to net revenues of $21,439,000 in the second quarter of fiscal 1998.
For the six months ended March 27, 1999, net revenues were $40,814,000 compared
to $43,910,000 for the same period of fiscal 1998. The decreases in net revenues
were primarily due to lower-than-expected photofinishing revenues. Management
attributes reduced photofinishing revenues to increased competition, primarily
relating to lower retail pricing of major film brands. In addition, the Company
reduced spending on marketing programs in the first half of fiscal 1999 as
compared to the prior year based on a planned shift in concentration of
marketing programs to the third and fourth quarters of fiscal 1999. Sales of
products and photofinishing supplies to commercial customers also decreased in
fiscal 1999 periods primarily due to the lower retail pricing of major film
brands which has reduced market share of private-label brands. Net revenues for
fiscal 1999 periods were also affected by a planned reduction in ancillary
businesses primarily related to wholesale film sales in Asia and the Company's
Photo Home Study continuity program.
Cost of goods and services consist of labor, postage, supplies and fixed
operating costs related to the Company's services and products. Gross profit in
the second quarter of fiscal 1999 decreased to 33.9% of net revenues compared to
42.1% in the second quarter of fiscal 1998. For the first six months of fiscal
1999, gross profit decreased to 34.9% compared to 42.2% for the same period of
fiscal 1998. The decreases in fiscal 1999 periods were due primarily to lower
net revenues combined with higher material and usage costs relating to
enhancements in digital and traditional services and products. Gross profit
also included higher retail and production labor and equipment costs.
Fluctuations in gross profit will occur in future periods due to the seasonal
nature of revenues, mix of product sales, level and nature of promotional
activities and other factors.
Total operating expenses in the second quarter of fiscal 1999 increased to
56.5% of net revenues compared to 34.5% in the second quarter of fiscal 1998.
For the first six months of fiscal 1999 total operating expenses increased to
50.5% of net revenues compared to 33.6% for the same period of fiscal 1998. The
increases in operating costs were due primarily to the acceleration in
amortization of previously deferred customer acquisition costs combined with
current customer acquisition and marketing expenditures for the quarter and six
month periods. Each year the Company prepares detailed plans for its various
marketing activities, including the mix between customer acquisition
expenditures and other marketing expenses. However, the Company occasionally
changes both the mix and total marketing expenditures between periods to take
advantage of marketing opportunities as they become available. Also, the
Company expects to amortize $4,200,000 of the remaining capitalized customer
acquisition expenditures in each of the two remaining quarters of fiscal 1999.
Accordingly, operating expenses will continue to be significantly higher in
fiscal 1999 compared to prior periods. Future periods may reflect increased or
decreased marketing costs due to the expensing of such costs as incurred, as
well as the timing and magnitude of marketing activities.
Marketing expenses include current period expenses associated with customer
acquisition, building brand awareness, testing of new marketing strategies and
marketing to existing customers. Marketing expenses in the second quarter of
fiscal 1999 increased to 27.0% of net revenues compared to 10.6% of net revenues
for the second quarter of fiscal 1998. For the first six months of fiscal 1999,
other marketing expenses were 23.0% of net revenues compared to 10.4% of net
revenues for the first six months of fiscal 1998. The increases were primarily
due to the expensing of current period acquisition costs as compared to the
prior periods.
Research and development expenses increased to $287,000 in the second
quarter of fiscal 1999 as compared to $153,000 for the second quarter of fiscal
1998. Research and development expenses for the first six months of fiscal 1999
increased to $455,000 as compared to $296,000 for the first six months of fiscal
1998. The increases in fiscal 1999 were due primarily to additional wages and
contract services incurred primarily to support the Company's digital imaging
development strategy. Research and development expenses consist primarily of
costs incurred in researching and developing new computerized digital imaging
concepts, developing computer software products and creating equipment necessary
to provide customers with new computer-related photographic services and
products, including online Internet services and products.
General and administrative expenses increased to $1,216,000 for the second
quarter of fiscal 1999 as compared to $1,043,000 for the second quarter of
fiscal 1998. General and administrative costs increased to $2,360,000 for the
first six months of fiscal 1999 as compared to $2,099,000 for the first six
months of fiscal 1998. The increases were due primarily to increases in legal
and professional fees combined with higher wages and benefits. General and
administrative expenses
Page 12 of 18
<PAGE>
consist of costs related to computer operations, human resource functions,
finance, accounting, legal, investor relations and general corporate activities.
Total other income for the second quarter of fiscal 1999 decreased to
$134,000 as compared to $163,000 for the second quarter of fiscal 1998. For the
first six months of fiscal 1999, total other income was $366,000 as compared to
$377,000 for the same period of fiscal 1998. The decreases in the fiscal 1999
periods were due primarily to losses related to the disposal of certain obsolete
assets.
Federal income taxes were recorded at a benefit rate of 40% for the first
six months of fiscal 1999 compared to an expense of 34.3% in the first six
months of fiscal 1998. The tax rate for the current fiscal year is affected by
the reversal of deferred tax liabilities in relation to deferred customer
acquisition costs. Other factors affecting the fiscal 1999 tax rate are tax
exempt interest and the federal research and development tax credit.
Net income as a percentage of net revenues decreased to a loss of 13.1% in
the second quarter of fiscal 1999 as compared to net income of 5.5% in the
second quarter of fiscal 1998. For the first six months of fiscal 1999 net
income as a percentage of net revenues decreased to a loss of 8.8% compared to
net income of 6.2% for the same period of fiscal 1998. The fiscal 1999 period
decreases were primarily due to increased operating expenses combined with a
decrease in net revenues and gross profit.
Liquidity and Capital Resources
- -------------------------------
As of April 30, 1999, the Company's principal sources of liquidity included
cash and short-term investments of $16,060,000 and an unused revolving line of
credit of $6,000,000. The ratio of current assets to current liabilities for
the Company was 3.7 to 1 at the end of the second quarter of fiscal 1999,
compared to 4.9 to 1 at September 26, 1998. During the first six months of
fiscal 1999, the Company increased inventory levels by $2,434,000 to accommodate
third and fourth quarter marketing plans and support planned for photofinishing
volumes. Accounts payable increased by $2,559,000 primarily due to inventory
purchases. Accounts receivable decreased by $877,000 primarily due to payments
received for wholesale film orders shipped in the fourth quarter of fiscal 1998,
sales of which were substantially discontinued in the fourth quarter of fiscal
1998.
On January 22, 1997, the Company announced that it may repurchase shares of
its Common Stock, either through open market purchases at prevailing market
prices, through block purchases or in privately negotiated transactions.
Repurchases may be commenced or discontinued by the Company at any time.
Although the number of shares to be repurchased is uncertain, any repurchased
shares will to some degree offset the dilutive effect on earnings per share of
shares of Common Stock issued under the Company's stock option and stock
purchase plans. During the first quarter of fiscal 1999 the Company repurchased
466,000 shares of its common stock at a total price of $1,493,000.
Although the Company does not currently have any fixed material commitments
with regard to capital expenditures, it currently expects to spend approximately
$4,500,000 during the remainder of fiscal 1999, principally for photofinishing
processing equipment, data storage and computer network equipment and for
leasehold improvements.
The Company currently anticipates that existing funds together with
anticipated cash flow from operations and the Company's available line of credit
of $6,000,000 will be sufficient to finance its operations and planned capital
expenditures and to service its indebtedness for the foreseeable future.
However, if the Company does not generate sufficient cash from operations to
satisfy its ongoing expenses, the Company will be required to seek external
sources of financing or to refinance its obligations. Possible sources of
financing include the sale of equity securities or additional bank borrowings.
There can be no assurance that the Company will be able to obtain adequate
financing in the future.
Year 2000
- ---------
The Company recognizes the need to ensure that its operations will not be
adversely affected by Year 2000 systems failures. Year 2000 issues arise
because some computer software and hardware ("computer systems") were designed
to handle only a two-digit year, not a four-digit year (e.g. 1999 is seen by the
computer as "99"). When the year 2000 begins, these computer systems may
interpret "00" as the year 1900 and not 2000, and could either stop processing
date-related computations or process them incorrectly.
Page 13 of 18
<PAGE>
In order to minimize the impact of the Year 2000 on the Company, a Year
2000 committee has been established for the evaluation and management of risks
associated with material Year 2000 issues. The committee's plan includes a
review of material computer and imbedded systems that the Company currently has
in place, modification or replacement of such systems if required, assessment of
Company's software products as relates to Year 2000 issues, inquiry to third-
party providers with whom the Company has material business relationships as to
their state of readiness for potential Year 2000 issues and the development of
contingency plans in the event material Year 2000 issues arise in Company or
third-party computer systems. The Company estimates that as of April 30, 1999,
it had completed approximately 80% of the initiatives that it believes will be
necessary to fully address potential Year 2000 issues relating to its computer
equipment and software. The projects are in process and expected to be
completed on or about June 30, 1999. The Company anticipates that testing of
additional systems and required modifications or replacements will be completed
by June 30, 1999. As of March 27, 1999, the Company has not expended any
material amount to address potential Year 2000 issues, exclusive of costs
associated with previously scheduled modifications, upgrades or replacements
unrelated to Year 2000 issues. Other non-Year 2000 information system efforts
have not been materially delayed or impacted by Year 2000 initiatives. The
Company does not anticipate spending material amounts for additional testing,
modification, upgrade and replacement related to Year 2000 during fiscal year
1999. Based on current and anticipated operating needs, many of the Company's
critical computer systems do not rely on a two-digit year field as part of the
process or are in the process of being replaced with more technologically
advanced versions. Each new system being installed has been reviewed for Year
2000 compliance. The computer systems that have been or are in the process of
being upgraded or replaced, include, but are not limited to, the Company's
accounting system, inventory control system, workstation and network operating
systems. The remaining computer and imbedded systems, including but not limited
to, plant equipment, alarm systems, phone equipment and general office equipment
are currently being reviewed for Year 2000 compliance as part of the overall
plan for testing and modification referenced above. The Company has determined
that most products the Company sells in the ordinary course of business do not
have issues relating to Year 2000. Software products previously supplied by the
Company, in some cases, may display an incorrect date but will continue to
function. At their option, customers may upgrade to newer versions of the
Company's software to correct the date display. Any Year 2000 issues in
products sold by the Company that are manufactured by another vendor will be
referred to that vendor.
In addition to reviewing its own computer systems, the Company has sent
letters to material third-party providers, including, but not limited to,
suppliers, product sponsors, financial institutions, service providers, and
other companies with which the Company has material business relationships in
order to assess these companies' state of Year 2000 readiness. These letters
request, among other things, disclosure of the companies' plans for minimizing
the impact of the Year 2000 on their computer systems and the Company. As of
April 30, 1999, the Company had received responses from approximately 50% of
such third parties, and 100% of the companies that have responded have provided
written assurances that they expect to address all their significant Year 2000
issues on a timely basis. A follow-up mailing to significant vendors and
service providers that did not initially respond, or whose responses were deemed
unsatisfactory by the Company, has been completed. To date, the Company has not
received from any third-party provider with which a material business
relationship exists notice of a material Year 2000 issue or inability to address
material Year 2000 issues prior to the Year 2000. The Company is not in a
position to verify whether third-party service providers are or will become Year
2000 ready apart from such assurances or until a Year 2000 issue arises. The
Company presently believes that the Year 2000 issue will not pose significant
operational problems for the Company. However, if all Year 2000 issues are not
properly identified, or assessment, remediation and testing are not effected
timely with respect to Year 2000 problems that are identified, there can be no
assurance that the Year 2000 issue will not materially adversely affect the
Company's results of operations or adversely affect the Company's relationships
with customers, vendors, or others. Additionally, there can be no assurance
that the Year 2000 issues of other entities will not have a material adverse
impact on the Company's systems or results of operations. If the Company were
to experience a material disruption in its computer systems from Year 2000
issues, the Company is prepared to conduct business, particularly the processing
of customer orders, utilizing manual processes and third party vendors and back-
up data routinely archived by the Company. The Company anticipates that the
cost of conducting business utilizing the Company's contingency plans would be
higher than conducting business utilizing current and anticipated operational
plans.
Page 14 of 18
<PAGE>
PART II -- OTHER INFORMATION
----------------------------
ITEM 1 - LEGAL PROCEEDINGS
For an update concerning the legal proceeding filed by Fuji Photo Film Co.,
Ltd. on February 13, 1998, see Note D of Notes to Consolidated Financial
Statements in Part I above.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS
On February 9, 1999, the Company held its annual meeting of shareholders.
The shareholders acted on the following matter at the annual meeting.
The following individuals were elected to the Company's Board of Directors,
to hold office for a three-year term and until his respective successor is duly
elected and qualified. The number of votes cast, the number of votes withheld,
and the number of broker non-votes are listed below.
<TABLE>
<CAPTION>
For Withheld Non-votes
---------- -------- ---------
<S> <C> <C> <C>
Peter H. van Oppen 15,390,599 235,978 N/A
Craig E. Tall 15,399,948 226,629 N/A
</TABLE>
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
---------
10.1 Supplemental lease agreement No. 5 with General
Services Administration dated February 10, 1999
27 Financial Data Schedule
(b) Reports on Form 8-K.
--------------------
None
Page 15 of 18
<PAGE>
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.
SEATTLE FILMWORKS, INC.
DATED: May 7, 1999 /s/ Gary R. Christophersen
--------------------------------------
Gary R. Christophersen
President/Chief Executive Officer
(Principal Executive Officer)
/s/ Case H. Kuehn
---------------------------------------
Case H. Kuehn
Vice President-Finance/Treasurer
(Principal Financial and Chief
Accounting Officer)
Page 16 of 18
<PAGE>
INDEX TO EXHIBITS
SEATTLE FILMWORKS, INC.
Quarterly Report on Form 10-Q
For The Quarter Ended March 27, 1999
<TABLE>
<CAPTION>
Exhibit Description Page No.
- ------- ----------- --------
<S> <C> <C>
10.1 Supplemental lease agreement No 5. with General Service Administration
dated February 10, 1999 18
27 Financial Data Schedule Edgar filing
</TABLE>
Page 17 of 18
<PAGE>
EXHIBIT 10.1
GENERAL SERVICES ADMINISTRATION SUPPLEMENTAL AGREEMENT DATE
PUBLIC BUILDINGS SERVICE NO. 5 FEB 10 1999
SUPPLEMENTAL LEASE AGREEMENT TO LEASE NO. GS-10PES-OL-5-42
ADDRESS OF PREMISES Federal Center South
1202 Warehouse
4735 E. Marginal Way South
Seattle, WA 98134
THIS AGREEMENT, made and entered into this date by and between Seattle
FilmWorks, Inc.
whose address is 1260 16th Avenue West
Seattle, WA 98119
hereinafter called the Lessee, and the UNITED STATES OF AMERICA, hereafter
called the Government:
WHEREAS, the parties hereto desire to amend the above Lease.
NOW THEREFORE, these parties for the considerations hereinafter mentioned
covenant and agree that the said Lease is amended, effective February 1, 1999,
as follows:
This SLA #5 (supplemental lease agreement) reflects an extension for one year
and a change in rental rate for the warehouse usage, therefore, Paragraphs 3B
and 4 are amended as follows:
3B. FIXED TERM: To have and to hold said premises with their appurtenances,
beginning February 1, 1999 and ending January 31, 2000. This agreement will
revert to a month-to-month occupancy, pending a negotiated agreement of renewal,
based on current market rates for like space. Lessee must notify the
Contracting Officer, in writing, of intent to renew, no later than thirty (30)
days prior to expiration of the initial lease term.
4. The Lessee shall pay the Lessor an annual rental of $288,486.00 (Two hundred
eighty eight thousand four hundred eighty six dollars and no/100), payable at
the rate of $24,040.50 (Twenty four thousand forty dollars and 50/100), per
month in advance. Rent for part of a month shall be prorated. All payments
shall be made payable to the General Services Administration and shall contain
the outlease number for identification purposes: GS-10PES-OL-5-42. All
payments are to be paid by check or money and mailed to the OFFICE OF FINANCE,
GENERAL SERVICES ADMINISTRATION, P.O. BOX 70697, CHICAGO, IL 60673, for receipt
on or before the first day of each month.
All other terms and conditions of the lease shall remain in force and effect.
IN WITNESS WHEREOF, the parties subscribed their names as of the above date.
________________________________________________________________________________
LESSEE Seattle FilmWorks, Inc.
BY //s// Case H. Kuehn Vice President, Treasurer & CFO
(Signature) (Title)
IN PRESENCE OF
//s// Mich Earl 1260 16th Ave. West, Seattle, WA 98119
(Signature) (Address)
UNITED STATES OF AMERICA
CONTRACTING OFFICER
BY: //s//Lorraine A. Parham GENERAL SERVICES ADMINISTRATION
(Signature) (Official Title)
Page 18 of 18
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM SEATTLE
FILMWORKS INC SECOND QUARTER 1999 10-Q AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> SEP-25-1999
<PERIOD-START> SEP-27-1998
<PERIOD-END> MAR-27-1999
<CASH> 16,036
<SECURITIES> 0
<RECEIVABLES> 1,037<F1>
<ALLOWANCES> 0
<INVENTORY> 9,995
<CURRENT-ASSETS> 29,187
<PP&E> 11,087<F1>
<DEPRECIATION> 0
<TOTAL-ASSETS> 49,264
<CURRENT-LIABILITIES> 7,805
<BONDS> 0
0
0
<COMMON> 163
<OTHER-SE> 38,569
<TOTAL-LIABILITY-AND-EQUITY> 49,264
<SALES> 0
<TOTAL-REVENUES> 40,814
<CGS> 26,557
<TOTAL-COSTS> 20,601
<OTHER-EXPENSES> (366)
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (5,978)
<INCOME-TAX> (2,393)
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (3,585)
<EPS-PRIMARY> (.22)
<EPS-DILUTED> 0
<FN>
<F1>ASSET VALUES REPRESENT NET AMOUNTS
</FN>
</TABLE>
