<PAGE>
FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: December 26, 1998 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 January 29, 1999, there were issued and outstanding 16,246,736 shares of
common stock, par value $.01 per share.
Index to Exhibits at Page 16
Page 1 of 16
<PAGE>
SEATTLE FILMWORKS, INC.
INDEX
-----
<TABLE>
<CAPTION>
Page No.
--------
PART I -- FINANCIAL INFORMATION
<S> <C>
Item 1 - Financial Statements 3-8
Consolidated Balance Sheets as of December 26, 1998
and September 26, 1998 3-4
Consolidated Statements of Operations for the first quarter
ended December 26, 1998 and December 27, 1997 5
Consolidated Statements of Cash Flows for the first quarter
ended December 26, 1998 and December 27, 1997 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 6 - Exhibits and Reports on Form 8-K 14
SIGNATURES 15
INDEX TO EXHIBITS 16
</TABLE>
Page 2 of 16
<PAGE>
PART I -- FINANCIAL INFORMATION
-------------------------------
ITEM 1 - FINANCIAL STATEMENTS
SEATTLE FILMWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
<TABLE>
<CAPTION>
(UNAUDITED) (NOTE)
December 26, September 26,
ASSETS 1998 1998
=================================================================================================
<S> <C> <C>
CURRENT ASSETS
Cash and cash equivalents $11,955 $11,780
Securities available-for-sale 3,934 4,555
Accounts receivable, net of allowance for doubtful accounts 1,290 1,914
Inventories 9,630 7,561
Capitalized promotional expenditures 105 121
Prepaid expenses and other 419 831
Deferred income taxes 363 387
------- -------
TOTAL CURRENT ASSETS 27,696 27,149
FURNITURE, FIXTURES, AND EQUIPMENT,
at cost, less accumulated depreciation 10,963 10,954
CAPITALIZED CUSTOMER ACQUISITION EXPENDITURES 12,600 16,800
DEPOSITS AND OTHER ASSETS 469 213
TOTAL ASSETS $51,728 $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 16
<PAGE>
SEATTLE FILMWORKS, INC.
CONSOLIDATED BALANCE SHEETS (continued)
(in thousands, except per share and share data)
<TABLE>
<CAPTION>
(UNAUDITED) (NOTE)
December 26, September 26,
LIABILITIES AND SHAREHOLDERS' EQUITY 1998 1998
================================================================================================
<S> <C> <C>
CURRENT LIABILITIES
Accounts payable $ 3,449 $ 2,359
Current portion of capital lease obligations 177 174
Accrued expenses 916 1,376
Accrued compensation 1,118 1,570
Income taxes payable 494 7
------- -------
TOTAL CURRENT LIABILITIES 6,154 5,486
LONG-TERM CAPITAL LEASE OBLIGATIONS, net of current portion 661 706
DEFERRED INCOME TAXES 3,657 5,223
------- -------
TOTAL LIABILITIES 10,472 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 16,246,736 162 167
Additional paid-in capital 15 981
Retained earnings 41,079 42,553
------- -------
TOTAL SHAREHOLDERS' EQUITY 41,256 43,701
------- -------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $51,728 $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 16
<PAGE>
SEATTLE FILMWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(in thousands, except per share and share data)
<TABLE>
<CAPTION>
First Quarter Ended
----------------------------
December 26, December 27,
1998 1997
================================================================================================
<S> <C> <C>
Net revenues $ 21,512 $ 22,471
Cost of goods and services 13,807 12,972
----------- -----------
GROSS PROFIT 7,705 9,499
Operating expenses:
Amortized customer acquisition costs 4,200 3,828
Marketing expenses 4,178 2,315
Research and development 168 143
General and administrative 1,144 1,056
----------- -----------
Total operating expenses 9,690 7,342
----------- -----------
INCOME (LOSS) FROM OPERATIONS (1,985) 2,157
Other income:
Interest income 232 214
----------- -----------
Total other income 232 214
----------- -----------
INCOME (LOSS) BEFORE INCOME TAXES (1,753) 2,371
Benefit (provision) for income taxes 701 (813)
----------- -----------
NET INCOME (LOSS) $ (1,052) $ 1,558
=========== ===========
Net Earnings (Loss) per Share-Basic and Diluted $(.06) $.09
=========== ===========
Weighted Average Shares and
Equivalents Outstanding - Diluted 16,338,000 17,640,000
=========== ===========
Weighted Average Shares - Basic 16,338,000 16,541,000
=========== ===========
</TABLE>
See notes to consolidated financial statements.
Page 5 of 16
<PAGE>
SEATTLE FILMWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(in thousands)
<TABLE>
<CAPTION>
First Quarter Ended
-----------------------------
December 26, December 27,
1998 1997
==============================================================================================
<S> <C> <C>
OPERATING ACTIVITIES:
- ---------------------
Net income (loss) $(1,052) $ 1,558
Charges to income not affecting cash:
Depreciation and amortization 1,140 919
Amortization of capitalized customer
acquisition expenditures 4,200 3,828
Deferred income taxes (1,542) -
Net change in receivables, inventories, payables and other (368) 2,187
Capitalized promotional expenditures, net 16 40
Additions to capitalized customer acquisition expenditures - (5,067)
------- -------
NET CASH FROM OPERATING ACTIVITIES 2,394 3,465
INVESTING ACTIVITIES:
- ---------------------
Purchase of furniture, fixtures, and equipment (1,405) (1,420)
Purchases of securities available-for-sale (422) (2,354)
Sales of securities available-for-sale 1,043 725
------- -------
NET CASH USED IN INVESTING ACTIVITIES (784) (3,049)
FINANCING ACTIVITIES:
- ---------------------
Proceeds from issuance of Common Stock 100 592
Payment on purchase of Common Stock (1,493) (2,637)
Payment on capital lease obligations (42) -
------- -------
NET CASH USED IN FINANCING ACTIVITIES (1,435) (2,045)
------- -------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 175 (1,629)
Cash and cash equivalents at beginning of period 11,780 10,252
------- -------
CASH AND CASH EQUIVALENTS
AT END OF PERIOD $11,955 $ 8,623
======= =======
</TABLE>
See notes to consolidated financial statements.
Page 6 of 16
<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 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 first quarter ended December 26, 1998 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.
For the first quarter 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
$565,000 or a loss of $.02 per share.
NOTE C -- RECLASSIFICATIONS
Certain prior year balances have been reclassified to conform to the
current year's presentation.
Page 7 of 16
<PAGE>
SEATTLE FILMWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE D -- CONTINGENCIES
The Company is a defendant in a legal proceeding 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 the alleged
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. An evidentiary hearing before an ITC
Administrative Law Judge ("ALJ") was held in November, 1998 and the ALJ is
expected to issue an initial decision in late February 1999. Such decision is
subject to review by the ITC Commissioners, who would then issue a final
decision, by May, 1999. That decision would be subject to appeal to the Federal
Circuit Court of Appeals. The ultimate outcome of this action and its impact on
the Company is not determinable at this time. In addition, the Company is
involved in various routine legal proceedings in the ordinary course of its
business.
NOTE E -- 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.
NOTE F -- EARNINGS PER SHARE
The Company calculates earnings per share in accordance with the Financial
Accounting Standards Board Statement of Financial Standards 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>
First Quarter Ended
----------------------------------------------
December 26, 1998 December 27, 1997
===========================================================================================================================
<S> <C> <C>
Numerator for basic and diluted earnings per share:
Net income (loss) $(1,052,000) $ 1,558,000
=========== ===========
Denominator:
Denominator for basic earnings per share - weighted-average shares 16,338,000 16,541,000
Effect of dilutive securities:
Stock options - * 1,099,000
----------- -----------
Denominator for diluted earnings per share 16,338,000 17,640,000
=========== ===========
BASIC EARNINGS (LOSS) PER SHARE $ (.06) $ .09
=========== ===========
DILUTED EARNINGS (LOSS) PER SHARE $ (.06) $ .09
=========== ===========
</TABLE>
* The exercise of stock options is not assured as the result would be anti-
dilutive.
Page 8 of 16
<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, growth in sales,
achievements, trends, new product or service development or introduction plans
or any other statement which may be construed as a prediction of future
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 results, achievements 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; 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. and its subsidiaries is a leading direct-to-consumer
marketer and provider of high-quality amateur traditional photofinishing and
digital 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 compares amortized expense of customer acquisition programs with the
actual profitability of such programs to assess
Page 9 of 16
<PAGE>
whether the costs are fully recoverable. Quarterly analyses prior to fiscal 1998
indicated that the marketing programs for 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 10-K filing, 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 the first quarter of fiscal 1999, the Company amortized $4,200,000 of
previously capitalized customer acquisition costs in
Page 10 of 16
<PAGE>
addition to current period marketing costs. The Company expects to amortize
$4,200,000 of the remaining capitalized customer acquisition expenditures in
each of the three remaining quarters of fiscal 1999. Accordingly, operating
expenses will significantly increase 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 customer acquisition activities.
Net loss for the first quarter of fiscal 1999 was $1,052,000, or a loss of
$.06 per share, compared to net income of $1,558,000 or diluted earnings per
share of $.09 for the first quarter 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 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>
First Quarter Ended
-----------------------------
December 26, December 27,
1998 1997
========================================================================
<S> <C> <C>
Net revenues 100.0% 100.0%
Cost of goods and services 64.2 57.7
----- -----
GROSS PROFIT 35.8 42.3
Operating expenses:
Amortized customer acquisition costs 19.5 17.0
Marketing expenses 19.4 10.3
Research and development .8 .7
General and administrative 5.3 4.7
----- -----
Total operating expenses 45.0 32.7
----- -----
INCOME (LOSS) FROM OPERATIONS (9.2) 9.6
Total other income 1.0 .9
----- -----
INCOME (LOSS) BEFORE INCOME TAXES (8.2) 10.5
Benefit (provision) for income taxes 3.3 (3.6)
----- -----
NET INCOME (LOSS) (4.9)% 6.9%
===== =====
</TABLE>
Page 11 of 16
<PAGE>
Net revenues for the first quarter of fiscal 1999 were $21,512,000 as compared
to net revenues of $22,471,000 in the first quarter of fiscal 1998. The decline
in net revenues was primarily attributable to ancillary businesses. During the
fourth quarter of fiscal 1998 wholesale film sales to certain markets in Asia
were discontinued along with a planned reduction in the Company's Photo Home
Study continuity program which has been phased out. Net revenues from core
photofinishing services and products increased 1.6% as compared to the first
quarter of fiscal 1998.
Cost of goods and services consist of labor, postage and supplies related
to the Company's services and products. Gross profit in the first quarter of
fiscal 1999 decreased to 35.8% of net revenues compared to 42.3% in the first
quarter of fiscal 1998. The decrease was due primarily to higher material and
equipment costs stemming from product and service enhancements, such as the move
from floppy disk to CD for the Company's Pictures On Disk(TM) product. In
addition, the decrease in gross profit reflects 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, intensity
of promotional activities and other factors.
Total operating expenses in the first quarter of fiscal 1999 increased to
45.0% of net revenues compared to 32.7% in the first quarter of fiscal 1998.
This increase was due primarily to the acceleration in amortization of
previously deferred customer acquisition costs combined with current customer
acquisition expenditures for the quarter. Each year the Company prepares
detailed plans for its various marketing activities, including the mix between
customer acquisition 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.
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 first quarter of
fiscal 1999 increased to 19.4% of net revenues compared to 10.3% of net revenues
for the first quarter of fiscal 1998. The increase was primarily due to the
expensing of current period acquisition costs as compared to the prior period.
Research and development expenses increased to $168,000 for the first
quarter of fiscal 1999 compared to $143,000 in the first quarter of fiscal 1998.
The increase was due primarily to additional wage costs to support the Company's
digital imaging development strategy. Research and development expenses consist
primarily of costs incurred in researching new computerized digital imaging
concepts, developing computer software products and creating equipment necessary
to provide customers with new computer-related photographic services and
products.
General and administrative expenses increased to $1,144,000 for the first
quarter of fiscal 1999 compared to $1,056,000 for the first quarter of fiscal
1998. The increase was due primarily to legal expenses associated with the
defense of an action filed by Fuji Photo Film Co., Ltd. with the International
Trade Commission and higher professional service fees. See Note D -
Contingencies above. General and administrative expenses consist of costs
related to computer operations, human resource functions, finance, legal,
accounting, investor relations and general corporate activities.
Total other income for the first quarter of fiscal 1999 increased to
$232,000 as compared to $214,000 for the first quarter of fiscal 1998. The
increase was primarily due to higher interest income.
Federal income taxes were a recorded at a benefit rate of 40% for the first
quarter of fiscal 1999 compared to an expense of 34.3% in the first quarter 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 4.9% in
the first quarter of fiscal 1999 as compared to net income of 6.9% in the first
quarter of fiscal 1998 primarily due to increased operating expenses combined
with a decrease in gross profit.
Page 12 of 16
<PAGE>
Liquidity and Capital Resources
As of January 29, 1999, the Company's principal sources of liquidity included
cash and short-term investments of $18,477,000 and an unused revolving line of
credit of $6,000,000. The ratio of current assets to current liabilities for
the Company was 4.5 to 1 at the end of the first quarter of fiscal 1999, down
from the current ratio of 4.9 to 1 at September 26, 1998 primarily due to
decreases in accounts receivable, prepaid expenses and accrued expenses
partially offset by increases in inventory and accounts payable. During the
first quarter of fiscal 1999, inventory increased by $2,069,000 due primarily to
film purchases. Accounts payable increased by $1,090,000 primarily due to
increased inventory purchases.
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 serve to offset the dilutive effect 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 for a total 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
$5,500,000 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.
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 January 29,
1999, it had completed approximately 75% 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 comprising the 75% of the
initiatives 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
December 26, 1998, 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
Page 13 of 16
<PAGE>
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
January 29, 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 and additional mailings will
be made in the effort to obtain responses. 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.
PART II -- OTHER INFORMATION
----------------------------
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
---------
27 Financial Data Schedule - 1999
(b) Reports on Form 8-K.
--------------------
None
Page 14 of 16
<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: February 8, 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 15 of 16
<PAGE>
INDEX TO EXHIBITS
SEATTLE FILMWORKS, INC.
Quarterly Report on Form 10-Q
For The Quarter Ended December 26, 1998
Exhibit Description Page No.
- ------- ----------- --------
27 Financial Data Schedule SEC Electronic Filing
Page 16 of 16
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM SEATTLE
FILMWORKS INC. FIRST QUARTER 1999 10 Q AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> SEP-25-1999
<PERIOD-START> SEP-27-1998
<PERIOD-END> DEC-26-1998
<CASH> 15,889
<SECURITIES> 0
<RECEIVABLES> 1,290<F1>
<ALLOWANCES> 0
<INVENTORY> 9,630
<CURRENT-ASSETS> 27,696
<PP&E> 10,963<F1>
<DEPRECIATION> 0
<TOTAL-ASSETS> 51,728
<CURRENT-LIABILITIES> 6,154
<BONDS> 0
0
0
<COMMON> 162
<OTHER-SE> 41,094
<TOTAL-LIABILITY-AND-EQUITY> 51,728
<SALES> 0
<TOTAL-REVENUES> 21,512
<CGS> 13,807
<TOTAL-COSTS> 9,690
<OTHER-EXPENSES> (232)
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (1,753)
<INCOME-TAX> (701)
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (1,052)
<EPS-PRIMARY> (.06)
<EPS-DILUTED> 0
<FN>
<F1>Asset values represent net amounts
</FN>
</TABLE>
