<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: June 26, 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 July 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 17
<PAGE>
SEATTLE FILMWORKS, INC.
INDEX
-----
Page No.
--------
PART I -- FINANCIAL INFORMATION
Item 1 - Financial Statements 3-8
Consolidated Balance Sheets as of June 26, 1999
and September 26, 1998 3-4
Consolidated Statements of Operations for the third quarter
and nine months ended June 26, 1999 and June 27, 1998 5
Consolidated Statements of Cash Flows for the nine months
ended June 26, 1999 and June 27, 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 6 - Exhibits and Reports on Form 8-K 15
SIGNATURES 16
INDEX TO EXHIBITS 17
EXHIBITS Edgar filing
Page 2 of 17
<PAGE>
PART I -- FINANCIAL INFORMATION
-------------------------------
ITEM 1 - FINANCIAL STATEMENTS
SEATTLE FILMWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
<TABLE>
<CAPTION>
(UNAUDITED) (NOTE)
June 26, September 26,
ASSETS 1999 1998
====================================================================================================
<S> <C> <C>
CURRENT ASSETS
Cash and cash equivalents $ 8,926 $11,780
Securities available-for-sale 4,887 4,555
Accounts receivable, net of allowance for doubtful accounts 1,571 1,914
Inventories 10,824 7,561
Capitalized promotional expenditures 15 121
Prepaid expenses and other 2,496 831
Deferred income taxes 406 387
------- -------
TOTAL CURRENT ASSETS 29,125 27,149
FURNITURE, FIXTURES, AND EQUIPMENT,
at cost, less accumulated depreciation 11,284 10,954
CAPITALIZED CUSTOMER ACQUISITION EXPENDITURES 4,200 16,800
DEPOSITS AND OTHER ASSETS 537 213
------- -------
TOTAL ASSETS $45,416 $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 17
<PAGE>
SEATTLE FILMWORKS, INC.
CONSOLIDATED BALANCE SHEETS (continued)
(in thousands, except per share and share data)
<TABLE>
<CAPTION>
(UNAUDITED) (NOTE)
June 26, September 26,
LIABILITIES AND SHAREHOLDERS' EQUITY 1999 1998
============================================================= ========== =============
<S> <C> <C>
CURRENT LIABILITIES
Accounts payable $ 6,090 $ 2,359
Current portion of capital lease obligations 183 174
Accrued expenses 1,143 1,376
Accrued compensation 1,648 1,570
Income taxes payable 7 7
---------- -------------
TOTAL CURRENT LIABILITIES 9,071 5,486
LONG-TERM CAPITAL LEASE OBLIGATIONS, net of current portion 568 706
DEFERRED INCOME TAXES 819 5,223
---------- -------------
TOTAL LIABILITIES 10,458 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 16,301,435 163 167
Additional paid-in capital 113 981
Retained earnings 34,412 42,553
---------- -------------
TOTAL SHAREHOLDERS' EQUITY 34,688 43,701
---------- -------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 45,146 $ 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 17
<PAGE>
SEATTLE FILMWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(in thousands, except per share and share data)
<TABLE>
<CAPTION>
Third Quarter Ended Nine Months Ended
-------------------------- -------------------------
June 26, June 27, June 26, June 27,
1999 1998 1999 1998
=========== =========== =========== ===========
<S> <C> <C> <C> <C>
Net revenues $ 22,801 $ 24,928 $ 63,615 $ 68,838
Cost of goods and services 14,938 14,293 41,495 39,673
----------- ----------- ----------- -----------
GROSS PROFIT 7,863 10,635 22,120 29,165
Operating expenses:
Amortized customer acquisition costs 4,200 3,995 12,600 11,767
Marketing expenses 8,621 2,196 18,007 6,774
Research and development 506 154 961 450
General and administrative 1,132 1,117 3,492 3,216
----------- ----------- ----------- -----------
Total operating expenses 14,459 7,462 35,060 22,207
----------- ----------- ----------- -----------
INCOME (LOSS) FROM OPERATIONS (6,596) 3,173 (12,940) 6,958
Other income (expense):
Interest income 183 152 603 541
Non-operating income (expense), net (58) 91 (112) 79
----------- ----------- ----------- -----------
Total other income 125 243 491 620
----------- ----------- ----------- -----------
INCOME (LOSS) BEFORE INCOME TAXES (6,471) 3,416 (12,449) 7,578
Benefit (Provision) for income taxes 2,337 (1,175) 4,730 (2,602)
----------- ----------- ----------- -----------
NET INCOME (LOSS) $ (4,134) $ 2,241 $ (7,719) $ 4,976
=========== =========== =========== ===========
Diluted Earnings (Loss) per Share $ (.25) $ .13 $ (.47) $ .28
=========== =========== =========== ===========
Basic Earnings (Loss) per Share $ (.25) $ .13 $ (.47) $ .30
=========== =========== =========== ===========
Weighted Average Shares and
Dilutive Equivalents Outstanding 16,300,000 17,490,000 16,298,000 17,540,000
=========== =========== =========== ===========
Weighted Average Shares - Basic 16,300,000 16,669,000 16,298,000 16,591,000
=========== =========== =========== ===========
</TABLE>
See notes to consolidated financial statements.
Page 5 of 17
<PAGE>
SEATTLE FILMWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(in thousands)
<TABLE>
<CAPTION>
Nine Months Ended
-------------------
June 26, June 27,
1999 1998
======== ========
<S> <C> <C>
OPERATING ACTIVITIES:
- ---------------------
Net income (loss) $ (7,719) $ 4,976
Charges to income not affecting cash:
Depreciation and amortization 3,452 2,648
Amortization of capitalized customer
acquisition expenditures 12,600 11,767
Deferred income taxes (4,423) 681
Net change in receivables, inventories, payables and other (1,009) (1,302)
Capitalized promotional expenditures, net 106 (91)
Additions to capitalized customer acquisition expenditures - (14,530)
-------- --------
NET CASH FROM OPERATING ACTIVITIES 3,007 4,149
INVESTING ACTIVITIES:
- ---------------------
Purchase of furniture, fixtures, and equipment (4,106) (4,932)
Purchases of securities available-for-sale (2,699) (5,456)
Sales of securities available-for-sale 2,367 4,345
-------- --------
NET CASH USED IN INVESTING ACTIVITIES (4,438) (6,043)
FINANCING ACTIVITIES:
- ---------------------
Payment on purchase of Common Stock (1,493) (2,670)
Proceeds from issuance of Common Stock 199 994
Payment on capital lease obligation (129) (47)
-------- --------
NET CASH USED IN FINANCING ACTIVITIES (1,423) (1,723)
-------- --------
DECREASE IN CASH AND CASH EQUIVALENTS (2,854) (3,617)
Cash and cash equivalents at beginning of period 11,780 10,252
-------- --------
CASH AND CASH EQUIVALENTS
AT END OF PERIOD $ 8,926 $ 6,635
======== ========
</TABLE>
See notes to consolidated financial statements.
Page 6 of 17
<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 image management services and
products. The Company offers an array of complementary services and products,
primarily through mail-order and Internet delivery systems, 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 third quarter and nine months ended June
26, 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 and 10-K/A 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 nine 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 $3,604,000 or a loss of $.15 per share.
NOTE C -- RECLASSIFICATIONS
Certain prior year balances have been reclassified to conform to the
current year's presentation.
Page 7 of 17
<PAGE>
SEATTLE FILMWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE D -- CONTINGENCIES
The Company was 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 was 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 5.1% during the first nine months
of fiscal 1999. An evidentiary hearing before an ITC Administrative Law Judge
("ALJ") was held in November, 1998 and the ALJ issued an initial decision in
favor of Fuji which the ITC Commissioners have decided to let stand. The ITC
Commissioners issued a final order in June, 1999 prohibiting the Company and its
subsidiaries from importing and selling imported recycled single use cameras.
The ITC Commissioners' order is 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. Fuji has
brought civil action for patent infringement against three other companies and
has stated in a press release that it is reviewing its options with respect to
other companies involved in the sale of products that infringe patents. If such
an action were brought against the Company, 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 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. The Company's Common Stock equivalents consist of stock options. The
dilutive effect of stock options, if any, is excluded from the calculation of
basic earnings (loss) per share and diluted loss per share, but included in the
computation of diluted earnings per share.
The following table sets forth the computation of basic and diluted
earnings (loss) per share:
<TABLE>
<CAPTION>
Third Quarter Ended Nine Months Ended
-------------------------------- -------------------------------
June 26, 1999 June 27, 1998 June 26, 1999 June 27, 1998
============= ============= ============= =============
<S> <C> <C> <C> <C>
Numerator for basic and diluted earnings per share:
Net income (loss) $(4,134,000) $ 2,241,000 $(7,719,000) $ 4,976,000
=========== =========== =========== ===========
Denominator:
Denominator for basic earnings per share -
weighted-average shares 16,300,000 16,669,000 16,298,000 16,591,000
Net effect of dilutive stock options - 821,000 - 949,000
----------- ----------- ----------- -----------
Denominator for diluted earnings per share 16,300,000 17,490,000 16,298,000 17,540,000
=========== =========== =========== ===========
Basic Earnings (Loss) per Share $ (.25) $ .13 $ (.47) $ .30
=========== =========== =========== ===========
Diluted Earnings (Loss) per Share $ (.25) $ .13 $ (.47) $ .28
=========== =========== =========== ===========
</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 17
<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-related image management services and
products. The Company offers an array of complementary services and products
primarily through mail-order and Internet delivery systems under the brand name
Seattle FilmWorks(R). The Company is an industry leader in providing digital
images on floppy disk or CD (Pictures On Disk(TM)) and over the Internet via its
PhotoMail(TM) Internet delivery service. Since mid-1998, the Company has been
providing archiving to its Pictures On Disk(TM) customers and in April 1999, the
Company began scanning and archiving digital versions of photos with all regular
film processing orders for which the customer has provided an e-mail address.
This web-based service, PhotoWorks(R), provides customers private on-line access
to their images. The Company intends to retain each customers' archive for the
life of the customer relationship. To promote its services 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 two rolls of film to users of personal computers,
together with materials promoting Pictures On Disk(TM), PhotoMail(TM) and most
recently, PhotoWorks(R).
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.
Page 9 of 17
<PAGE>
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" served 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 were assessed each quarter based on identifiable responses to
the programs for which costs were 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 were 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
the Company's historical direct marketing programs as consumer behavior changes.
The Company is actively pursuing Internet opportunities related to its on-
line image storage and image management systems. The Company is also testing
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
Page 10 of 17
<PAGE>
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 marketing 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 three 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 the remaining
$4,200,000 of capitalized customer acquisition expenditures in the fourth
quarter of fiscal 1999. Accordingly, operating expenses will be significantly
higher in fiscal 1999 compared to prior periods. Future periods may reflect
increased or decreased marketing expenses due to the expensing of such costs as
incurred, as well as the timing and magnitude of marketing activities.
Net loss for the first nine months of fiscal 1999 was $7,719,000, or a loss
of $.47 per share, compared to net income of $4,976,000, or diluted earnings per
share of $.28 for the nine 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 seasonal nature and mix of
sales, level and nature of marketing 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 effectiveness of
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 historical 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>
Third Quarter Ended Nine Months Ended
--------------------- --------------------
June 26, June 27, June 26, June 27,
1999 1998 1999 1998
========== ========= ========= =========
<S> <C> <C> <C> <C>
Net revenues 100.0% 100.0% 100.0% 100.0%
Cost of goods and services 65.5 57.3 65.2 57.6
------ ----- ------ -----
GROSS PROFIT 34.5 42.7 34.8 42.4
Operating expenses:
Amortized customer acquisition costs 18.4 16.0 19.8 17.1
Marketing expenses 37.8 8.8 28.3 9.8
Research and development 2.2 0.6 1.5 0.7
General and administrative 5.0 4.5 5.5 4.7
------ ----- ------ -----
Total operating expenses 63.4 29.9 55.1 32.3
------ ----- ------ -----
INCOME (LOSS) FROM OPERATIONS (28.9) 12.8 (20.3) 10.1
Total other income 0.5 0.9 0.8 0.9
------ ----- ------ -----
INCOME (LOSS) BEFORE INCOME TAXES (28.4) 13.7 (19.5) 11.0
Benefit (provision) for income taxes 10.3 4.7 7.4 3.8
------ ----- ------ -----
NET INCOME (LOSS) (18.1)% 9.0% (12.1)% 7.2%
====== ===== ====== =====
</TABLE>
Page 11 of 17
<PAGE>
Net revenues for the third quarter of fiscal 1999 decreased 8.5% to
$22,801,000 as compared to net revenues of $24,928,000 in the third quarter of
fiscal 1998. For the nine months ended June 26, 1999, net revenues decreased
7.6% to $63,615,000 compared to $68,838,000 for the same period of fiscal 1998.
Lower net revenues for the third quarter and for the first nine months in fiscal
1999 were primarily due to lower photofinishing revenues which management
attributes to increased competition, primarily relating to lower retail pricing
of major film brands. In addition, the Company reduced spending on marketing
programs during the first six months of fiscal 1999 as compared to the prior
year due to a planned shift in the concentration of its marketing programs to
the third and fourth quarters of fiscal 1999. Net revenues for the fiscal 1999
periods were also affected by a planned reduction in ancillary businesses
primarily related to discontinued wholesale film sales in Asia.
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 third quarter of fiscal 1999 declined to 34.5% of net revenues compared to
42.7% in the third quarter of fiscal 1998. For the first nine months of fiscal
1999, gross profit declined to 34.8% compared to 42.4% for the same period of
fiscal 1998. This decline was primarily due to lower net revenues combined with
higher equipment and material costs relating to enhancements in digital and
traditional services and products as well as higher retail and production labor
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 marketing
activities and other factors.
Total operating expenses in the third quarter of fiscal 1999 increased to
63.4% of net revenues compared to 29.9% in the third quarter of fiscal 1998.
For the first nine months of fiscal 1999, total operating expenses increased to
55.1% compared to 32.3% for the same period of fiscal 1998. The increase in
operating costs for the third quarter of fiscal 1999 was primarily due to the
acceleration in amortization of previously deferred customer acquisition costs
combined with planned increases in marketing expenditures. The Company is
actively marketing its on-line Internet imaging services and plans additional
marketing and advertising expenditures to promote this and other new digital
services and products. In addition, the Company expects to amortize the
remaining $4,200,000 of capitalized customer acquisition expenditures in the
fourth quarter 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 costs associated with customer acquisition and
retention, building brand awareness, and testing of new marketing programs.
Marketing expenses in the third quarter of fiscal 1999 increased to 37.8% of net
revenues compared to 8.8% of net revenues for the third quarter of fiscal 1998.
For the first nine months of fiscal 1999, marketing expenses were 28.3% of net
revenues compared to 9.8% of net revenues for the first nine months of fiscal
1998. The increases in the fiscal 1999 periods were primarily due to the
expensing of current period marketing costs combined with planned increases in
marketing expenditures scheduled for the third and fourth quarters of fiscal
1999.
Research and development expenses increased to $506,000 in the third
quarter of fiscal 1999 as compared to $154,000 for the third quarter of fiscal
1998. Research and development expenses for the first nine months of fiscal
1999 increased to $961,000 as compared to $450,000 for the first nine months of
fiscal 1998. The increases are due primarily to higher labor and development
costs associated with the Company's expanding array of digital products and
services. Research and development expenses consist primarily of costs incurred
in developing computerized image management concepts, developing on-line photo
archiving and photo sharing services, and creating equipment necessary to
provide customers with new computer-related photographic services and products.
General and administrative expenses increased to $1,132,000 for the third
quarter of fiscal 1999 as compared to $1,117,000 for the third quarter of fiscal
1998. General and administrative costs increased to $3,492,000 for the first
nine months of fiscal 1999 as compared to $3,216,000 for the first nine months
of fiscal 1998. The increases were due primarily to labor and equipment
increases in Information Systems and administration to support the Company's
growing computer-based and Internet-related operations. General and
administrative expenses consist of costs related to computer operations, human
resource functions, finance, accounting, legal, investor relations and general
corporate activities.
Page 12 of 17
<PAGE>
Total other income for the third quarter of fiscal 1999 decreased to
$125,000 as compared to $243,000 for the third quarter of fiscal 1998. For
fiscal 1999, total other income was $491,000 as compared to $620,000 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. In
addition, other income in fiscal 1998 included special vendor discounts from
materials purchased.
Federal income taxes were recorded at a benefit rate of 38% for the first
nine months of fiscal 1999 compared to an expense of 34.3% in the first nine
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 1999 tax rate are tax exempt
interest and the federal research and development tax credit.
The net loss in the third quarter of fiscal 1999 was $4,134,000, compared
to net income of $2,241,000 in the third quarter of fiscal 1998. Net loss for
the first nine months of fiscal 1999 was $7,719,000 compared to net income of
$4,976,000 for the first nine months of fiscal 1998. The decline in the fiscal
1999 periods was primarily due to increased operating expenses combined with a
decrease in net revenues and gross profit.
Liquidity and Capital Resources
- -------------------------------
As of July 30, 1999, the Company's principal sources of liquidity included
cash and short-term investments of $15,464,000 and an unused revolving line of
credit of $6,000,000. The ratio of current assets to current liabilities for
the Company was 3.2 to 1 at the end of the third quarter of fiscal 1999,
compared to a current ratio of 4.9 to 1 at September 26, 1998. The Company
increased inventory levels by $3,263,000 to accommodate expanded marketing plans
and seasonal volumes. Prepaid expenses increased by $1,665,000 primarily due to
the timing of federal income tax payments. Accounts payable increased by
$3,731,000 primarily as a result of 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 subject
to certain conditions established by the Company's Board of Directors. 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 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
$2,000,000 during the remainder of fiscal 1999, principally for photofinishing
equipment and data storage and computer network equipment to support its digital
and Internet-related on-line archive and image management services.
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, marketing 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 17
<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 July 30, 1999,
it had completed approximately 90% 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 September 30, 1999.
As of June 26, 1999, the Company has not expended any significant amounts
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 significant 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, payroll 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
requested, 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
July 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 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 17
<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 6 - EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
---------
27 Financial Data Schedule
(b) Reports on Form 8-K.
--------------------
None
Page 15 of 17
<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: August 4, 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 17
<PAGE>
INDEX TO EXHIBITS
SEATTLE FILMWORKS, INC.
Quarterly Report on Form 10-Q
For The Quarter Ended June 26, 1999
Exhibit Description Page No.
- ------- ----------- --------
27 Financial Data Schedule Edgar filing
Page 17 of 17
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM SEATTLE
FILMWORKS INC THIRD QUARTER 1999 10Q AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> SEP-25-1999
<PERIOD-START> SEP-27-1998
<PERIOD-END> JUN-26-1999
<CASH> 13,813
<SECURITIES> 0
<RECEIVABLES> 1,571<F1>
<ALLOWANCES> 0
<INVENTORY> 10,824
<CURRENT-ASSETS> 29,125
<PP&E> 11,284<F1>
<DEPRECIATION> 0
<TOTAL-ASSETS> 45,146
<CURRENT-LIABILITIES> 9,071
<BONDS> 0
0
0
<COMMON> 163
<OTHER-SE> 34,525
<TOTAL-LIABILITY-AND-EQUITY> 45,146
<SALES> 0
<TOTAL-REVENUES> 63,615
<CGS> 41,495
<TOTAL-COSTS> 35,060
<OTHER-EXPENSES> (491)
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (12,449)
<INCOME-TAX> (4,730)
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (7,719)
<EPS-BASIC> (.47)
<EPS-DILUTED> 0
<FN>
<F1>ASSET VALUES REPRESENT NET AMOUNTS
</FN>
</TABLE>
