DAMARK INTERNATIONAL INC, 10-Q, 2000-08-15

DAMARK INTERNATIONAL INC
10-Q, 2000-08-15
CATALOG & MAIL-ORDER HOUSES

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

/x/	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 1, 2000

/ /	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number: 0-19902

DAMARK INTERNATIONAL, INC.
(Exact name of Registrant as specified in its charter)

Minnesota (State or other jurisdiction of incorporation or organization)		41-1551116 (IRS Employer Identification Number)
301 Carlson Parkway, Suite 201 Minneapolis, Minnesota 55305 (Address of principal executive offices)		952-258-2000 (Registrant's telephone number including area code)

7101 Winnetka Avenue North
Minneapolis, MN 55428
(Former name, former address and former fiscal year, if changed since last report)

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 Act of 1934 during the preceding 12 months; and (2) has been subject to such filing requirements for the past 90 days. Yes /x/ No / /

On August 3, 2000, there were 5,767,937 shares of Class A Common Stock and no shares of Class B Common Stock outstanding.

DAMARK INTERNATIONAL, INC.

INDEX

			Page
Part I.	FINANCIAL INFORMATION
	Item 1:	Financial Statements
		Consolidated Statements of Operations (unaudited) For the three and six months ended July 1, 2000 and July 3, 1999	3
		Consolidated Balance Sheets As of July 1, 2000 (unaudited) and December 31, 1999	4
		Consolidated Statements of Cash Flows (unaudited) For the six months ended July 1, 2000 and July 3, 1999	5
		Condensed Notes to Consolidated Financial Statements	6
	Item 2:	Management's Discussion and Analysis of Financial Condition and Results of Operations	14
Part II.	OTHER INFORMATION
	Item 1:	Legal Proceedings	21
	Item 6:	Exhibits and Reports on Form 8-K	21
		Signature	22

DAMARK INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

		Three months ended						Six months ended
		July 1, 2000			July 3, 1999			July 1, 2000			July 3, 1999
		(Amounts in thousands except per share data)
Net revenues:
Product and other revenues		$	17,729		$	77,692		$	57,112		$	162,042
Membership and related revenues			34,044			34,554			70,183			59,632

	Total net revenues		51,773			112,246			127,295			221,674

Costs and expenses:
Cost of products sold			16,680			55,558			48,496			117,129
Operating and marketing expenses			35,526			43,721			79,380			79,295
General and administrative expenses			11,673			15,219			23,261			28,574
Restructuring charges			2,259			—			8,998			—

	Total costs and expenses		66,138			114,498			160,135			224,998

	Operating loss		(14,365	)		(2,252	)		(32,840	)		(3,324	)
Interest expense, net			280			255			478			544
Other expenses, net			31			119			160			131

	Loss before income taxes, extraordinary gain and cumulative effect of change in accounting		(14,676	)		(2,626	)		(33,478	)		(3,999	)
Income tax benefit			5,858			893			12,700			1,360

	Net loss before extraordinary gain and cumulative effect of change in accounting		(8,818	)		(1,733	)		(20,778	)		(2,639	)
Extraordinary gain on condemnation of land, net of taxes of $153			—			297			—			297
Cumulative effect of change in accounting, net of taxes of $8,703			—			—			(14,201	)		—

	Net loss	$	(8,818	)	$	(1,436	)	$	(34,979	)	$	(2,342	)

Loss per common share, basic and diluted:
	Loss before extraordinary gain and cumulative effect of change in accounting	$	(1.53	)	$	(0.29	)	$	(3.64	)	$	(0.44	)
	Extraordinary gain		—			0.05			—			0.05
	Cumulative effect of change in accounting		—			—			(2.49	)		—

	Net loss	$	(1.53	)	$	(0.24	)	$	(6.13	)	$	(0.39	)

	Weighted average common shares outstanding		5,761			5,993			5,702			5,990

Pro forma amounts assuming retroactive application of Staff Accounting Bulletin No. 101:
	Net loss	$	(8,818	)	$	(1,032	)	$	(20,778	)	$	(8,887	)

	Basic and diluted loss per common share	$	(1.53	)	$	(0.17	)	$	(3.64	)	$	(1.48	)

See accompanying condensed notes to consolidated financial statements.

DAMARK INTERNATIONAL, INC.

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(Amounts in thousands except per share data)				July 1, 2000			December 31, 1999
ASSETS
Current Assets:
	Cash and cash equivalents			$	449		$	3,927
	Trade accounts receivable, net				28,860			43,847
	Merchandise inventories, net				1,352			30,739
	Deferred membership solicitation and catalog costs				30,870			15,186
	Deferred income taxes				1,360			1,360
	Officer note receivable				1,720			—
	Other				1,267			1,366

		Total current assets			65,878			96,425
Property and equipment, net					23,086			25,464
Deferred income taxes					23,462			2,059
Officer note receivable					—			1,633
Other assets, net					167			465

		Total assets		$	112,593		$	126,046

LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities:
	Accounts payable			$	14,208		$	30,568
	Accrued liabilities				44,103			41,312
	Deferred membership income, net				46,548			24,749
	Borrowings under revolving credit facility				11,543			—

		Total current liabilities			116,402			96,629
Commitments and contingencies (Note 8)
Shareholders' Equity:
	Class A Common Stock, $.01 par, 20 million shares authorized; 5,766 and 5,520 shares issued and outstanding at July 1, 2000 and December 31, 1999, respectively				58			55
	Class B Common Stock, $.01 par, 2 million shares authorized; none issued and outstanding				—			—
	Series C Junior Participating Preferred Stock, $.01 par, 400,000 shares authorized; none issued and outstanding				—			—
	Paid-in capital				56,360			54,610
	Accumulated deficit				(60,227	)		(25,248	)

		Total shareholders' equity (deficit)			(3,809	)		29,417

			Total liabilities and shareholders' equity	$	112,593		$	126,046

See accompanying condensed notes to consolidated financial statements.

DAMARK INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

				Six Months Ended
				July 1, 2000			July 3, 1999
				(Amounts in thousands)
OPERATING ACTIVITIES:
	Net loss			$	(34,979	)	$	(2,342	)
	Adjustments to reconcile net loss to net cash provided by (used for) operations:
		Extraordinary gain on condemnation of land, net			—			(297	)
		Cumulative effect of change in accounting, net			14,201			—
		Depreciation and amortization			8,611			4,151
		Deferred income taxes			(12,700	)		(1,360	)
		Loss on disposal of property and equipment			67			80
		Changes in working capital items:
			Trade accounts receivable, net		14,987			6,069
			Merchandise inventories, net		29,387			15,270
			Other current assets		7,973			(1,658	)
			Accounts payable and accrued liabilities		(29,205	)		(13,069	)
			Deferred membership income, net		(14,166	)		2,926

	Net cash (used for) provided by operations				(15,824	)		9,770

INVESTING ACTIVITIES:
	Property and equipment additions				(1,594	)		(2,194	)
	Proceeds from sale of property and equipment				741			—
	Issuance of officer note receivable				—			(1,500	)
	Other, net				(97	)		(23	)

	Net cash used for investing activities				(950	)		(3,717	)

FINANCING ACTIVITIES:
	Borrowings under revolving credit facility, net				11,543			(4,855	)
	Repurchase and retirement of common stock				—			(1,741	)
	Net proceeds from employee exercise of stock options and issuance of stock				1,753			780

	Net cash provided by (used for) financing activities				13,296			(5,816	)

	Net increase (decrease) in cash and cash equivalents				(3,478	)		237
	Cash and cash equivalents, beginning of period				3,927			49

	Cash and cash equivalents, end of period			$	449		$	286

SUPPLEMENTAL CASH FLOW INFORMATION:
	Interest paid during the period			$	540		$	455

	Income taxes refunded during the period			$	(1,874	)	$	(781	)

	Non-cash property and equipment additions			$	5,468		$	—

See accompanying condensed notes to consolidated financial statements.

DAMARK INTERNATIONAL, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Basis of Presentation

The unaudited consolidated financial statements included herein have been prepared by Damark International, Inc. (the "Company") pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). The information furnished in these financial statements includes normal recurring adjustments and reflects all adjustments, which are, in the opinion of management, necessary for a fair presentation of such financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. Although the Company believes that the disclosures are adequate to make the information presented not misleading, these financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company's 1999 Annual Report on Form 10-K filed with the SEC.

The Company's fiscal year ends on December 31; however, each quarter ends on the last Saturday of a thirteen-week period. As a result, the operating results for the first half of 2000 and 1999 included 183 and 184 days, respectively. Management believes that the difference in days does not materially affect the comparability of financial results for the periods presented.

In January 2000, the Company announced that it would wind-down its non-member catalog marketing and merchandising activities. Going forward, catalog mailings will be limited to members of the Company's shopping clubs. The wind-down was substantially completed by the end of the second quarter. The Company will continue to operate its membership services business which recently started doing business as Provell. The order capture, product fulfillment and customer service capabilities developed by the Company were redeployed into a subsidiary named ClickShip Direct, Inc. ("ClickShip"), which was formed in January 2000. The Company currently plans to separate ClickShip as an independent company (the manner and tax treatment of which has not yet been finalized) during the third or fourth quarter of 2000.

Note 2. Cumulative Effect of Change in Accounting Principle

In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101—Revenue Recognition in Financial Statements ("SAB 101"). The Company adopted SAB 101 effective January 1, 2000 and recorded a non-cash charge of $22.9 million ($14.2 million net of taxes). Prior to the adoption of SAB 101, membership revenues with respect to clubs for which the Company had an ongoing obligation were recorded on the balance sheet net of direct solicitation and other costs and amortized into income over the membership period, generally twelve months. Revenues and related expenses on clubs for which the Company had no significant ongoing obligation were recognized immediately, net of an accrual for future anticipated returns, once any trial period had elapsed.

Effective January 1, 2000 with the adoption of SAB 101, the Company defers all membership revenues, net of estimated returns, and amortizes them into revenue on a straight line basis after the trial period has elapsed and over the remaining membership period, generally twelve months. The allowance for returns is established based on the Company's most recent return experience which is updated each quarter. Most of the Company's members can return their membership at any time prior to expiration of the membership term and receive a pro-rated refund for the remaining portion of the

membership period. Second quarter and first half activity in the deferred membership income and accrued membership returns accounts is summarized as follows (000's):

Quarter ended July 1, 2000:

	Balance at April 1, 2000		Additions		Reductions			Adjustments(1)			Balance at July 1, 2000
Deferred membership income	$	48,067	$	25,754	$	(30,657	)	$	3,385		$	46,549

Accrued membership returns	$	26,501	$	24,265	$	(22,243	)	$	(4,984	)	$	23,539

Six months ended July 1, 2000:

	Balance at Dec. 31, 1999		Additions		Reductions			Adjustments(2)		Balance at July 1, 2000
Deferred membership income	$	24,749	$	43,568	$	(62,943	)	$	41,175	$	46,549

Accrued membership returns	$	16,911	$	55,338	$	(52,432	)	$	3,722	$	23,539

(1): Adjustments relate primarily to reclassifications between accrued returns and deferred income.
(2): Adjustments relate primarily to the initial adoption of SAB 101.

During the second quarter and first half of 2000, the Company recognized $10.6 million and $27.4 million, respectively, of net revenue which was included as a component of the "cumulative effect of change in accounting" adjustment.

Effective with the adoption of SAB 101, the Company also defers the recognition of costs and revenues associated with extended warranty service contracts until the end of the return period, generally three months. Previously, such revenues and costs were recognized immediately.

In accordance with SAB 101, the cost of membership kits and vouchers are expensed when distributed. Refundable fees for commissions paid to clients and transaction processing costs, net of expected refunds, together with direct response advertising costs (i.e., telemarketing and direct mail), are capitalized as part of deferred membership solicitation costs and are amortized as expense in the same manner in which the related revenue is recognized. Other direct and indirect costs incurred with enrolling customers are expensed when incurred. Membership solicitation costs incurred to obtain new members are generally less than the initial fee. However, if membership solicitation costs were to exceed membership fees, an adjustment would be made to the extent of any impairment.

Note 3. Earnings Per Common Share

Basic earnings per share ("EPS") is computed based on the weighted average shares of common stock outstanding during the applicable periods while diluted EPS is computed based on the weighted average shares of common stock outstanding plus potentially dilutive securities outstanding during the

applicable periods. Potentially dilutive securities include stock options which have been granted to employees and directors of the Company.

		Net loss			Weighted average shares outstanding	Per share amount
Quarter ended July 1, 2000:
	Basic and diluted	$	(8,818	)	5,761	$	(1.53	)

Six months ended July 1, 2000:
	Basic and diluted	$	(34,979	)	5,702	$	(6.13	)

Quarter ended July 3, 1999:
	Basic and diluted	$	(1,436	)	5,993	$	(0.24	)

Six months ended July 3, 1999:
	Basic and diluted	$	(2,342	)	5,990	$	(0.39	)

For the three and six months ended July 1, 2000 and July 3, 1999, there were no potentially dilutive securities. Options to purchase 1,506,247 and 1,867,167 shares of the Company's Class A Common Stock (the "Common Stock"), respectively, were not included in the computation of diluted loss per share as their inclusion would have been anti-dilutive.

Note 4. Shareholders' Equity

During the first half of 1999, the Company repurchased approximately 230,000 shares of its Common Stock in open market transactions at an aggregate cost of approximately $1.7 million. During the fourth quarter of 1999, the Board authorized a one million share open market repurchase program. Through July 1, 2000, no shares have been repurchased under this program.

Note 5. Restructuring Charges

In conjunction with the restructuring of the Company's catalog operations discussed in Note 1, approximately 150 jobs were eliminated, primarily in catalog marketing, merchandising and in closing the Brooklyn Center, Minnesota telemarketing center.

As a result of these activities, the Company recorded a pre-tax restructuring charge of $9.0 million during the first half of 2000. Included in the charge is approximately $1.3 million related to employee severance and termination costs (with no remaining balance to be paid at July 1, 2000), $1.9 million for future lease and other minimum commitments with no future benefit and $5.8 million for accelerated depreciation expense as a result of changes in the estimated useful lives of fixed assets that will only be used during certain transition periods. During the third and fourth quarters of 2000, the Company expects to record an additional $200,000 to $400,000 of incremental depreciation expense as an additional component of the restructuring charge.

Note 6. Business Segments

During the first six months of 2000 and 1999, the Company operated in two business segments: Membership Services and Catalog Retail. These reportable operating segments are strategic business units that offer different products and services and are managed separately based on fundamental

differences in their operations. Both operating segments sell exclusively to customers in the U.S. A Corporate segment is also used to account for certain unallocated items, capital allocation and taxes. The disaggregated financial information presented below is consistent with the basis and manner in which management evaluates results for purposes of assistance with internal operating decisions.

The Membership Services operating segment develops, markets and manages leading edge membership and customer relationship management programs that provide purchase price discounts and other benefits related to consumer and small business needs in the areas of shopping, travel, hospitality, entertainment, health/fitness and finance.

The Company's Catalog Retail operating segment includes the results of operations from the wind-down of the Company's non-member catalog business and of its newly formed subsidiary ClickShip Direct, Inc. The catalog business offered brand name, value-priced merchandise through a variety of catalog titles in the categories of computers, home office, consumer electronics, home décor, home improvement and sports/fitness and provides outsourcing of order fulfillment and customer care services to retailers, direct marketers, and manufacturers. Services provided by ClickShip Direct include online and offline order-capture, payment processing, inventory receipt, warehousing, merchandise shipment, after-the-sale customer service and support and returns management.

The Catalog Retail segment provided certain discounts to members of the Preferred Buyers' Club® and Insiders® membership programs managed by the Membership Services segment. The Catalog Retail segment experienced significantly higher advertising leverage on catalogs sent to club members due to the fact that member response rates were typically up to two times higher than those of other customer segments. In addition, member sales per catalog were typically two to three times higher than those of other customer segments. For these reasons, discounts were allocated entirely to the Catalog Retail segment.

Selected statement of operations and statement of cash flows data for the three and six months ended July 1, 2000 and July 3, 1999 by business segment are set forth below. Amounts related to Membership Services reflect the impact of SAB 101 effective January 1, 2000 (see Note 2).

			Catalog Retail(1)			Membership Services		Corporate			Consolidated
			(Amounts in thousands)
Three Months Ended July 1, 2000
Net revenues(1)			$	17,729		$	34,044	$	—		$	51,773
Cost of products sold				16,680			—		—			16,680
Restructuring charges				2,259			—		—			2,259
Other expenses(2), (3)				22,785			24,414		—			47,199

	Operating (loss) income			(23,995	)		9,630		—			(14,365	)
Interest and other expense, net				18			13		280			311

	(Loss) income before taxes			(24,013	)		9,617		(280	)		(14,676	)
Income tax benefit				—			—		5,858			5,858

	Net (loss) income			(24,013	)		9,617		5,578			(8,818	)
Depreciation and amortization				3,391			119		—			3,510
Net changes in working capital and other				20,126			281		(12,952	)		7,455

		Net cash provided by (used for) operations	$	(496	)	$	10,017	$	(7,374	)	$	2,147

			Catalog Retail(1)			Membership Services		Corporate			Consolidated
			(Amounts in thousands)
Three Months Ended July 3, 1999
Net revenues(1)			$	77,692		$	34,554	$	—		$	112,246
Cost of products sold				55,558			—		—			55,558
Other expenses(2), (3)				30,229			27,401		1,310			58,940

	Operating (loss) income			(8,095	)		7,153		(1,310	)		(2,252	)
Interest and other expense, net				—			—		374			374

	(Loss) income before taxes and extraordinary gain			(8,095	)		7,153		(1,684	)		(2,626	)
Income tax benefit				—			—		893			893

	Net (loss) income before extraordinary gain			(8,095	)		7,153		(791	)		(1,733	)
Extraordinary gain(4)				450			—		(153	)		297

	Net (loss) income			(7,645	)		7,153		(944	)		(1,436	)
Depreciation and amortization				1,482			530		48			2,060
Net changes in working capital and other				8,233			5,261		(548	)		12,946

		Net cash provided by (used for) operations	$	2,070		$	12,944	$	(1,444	)	$	13,570

			Catalog Retail(1)			Membership Services			Corporate			Consolidated
			(Amounts in thousands)
Six Months Ended July 1, 2000
Net revenues(1)			$	57,112		$	70,183		$	—		$	127,295
Cost of products sold				48,496			—			—			48,496
Restructuring charges				8,998			—			—			8,998
Other expenses(2), (3)				53,458			49,183			—			102,641

	Operating (loss) income			(53,840	)		21,000			—			(32,840	)
Interest and other expense, net				91			36			511			638

	(Loss) income before taxes and other			(53,931	)		20,964			(511	)		(33,478	)
Income tax benefit				—			—			12,700			12,700

	Net (loss) income before cumulative effect of change in accounting			(53,931	)		20,964			12,189			(20,778	)
Cumulative effect of change in accounting				—			(22,904	)		8,703			(14,201	)

	Net (loss) income			(53,931	)		(1,940	)		20,892			(34,979	)
Depreciation and amortization				8,198			397			16			8,611
Net changes in working capital and other				35,281			15,300			(40,037	)		10,544

		Net cash provided by (used for) operations	$	(10,452	)	$	13,757		$	(19,129	)	$	(15,824	)

			Catalog Retail(1)			Membership Services			Corporate			Consolidated
			(Amounts in thousands)
Six Months Ended July 3, 1999
Net revenues(1)			$	162,042		$	59,632		$	—		$	221,674
Cost of products sold				117,129			—			—			117,129
Other expenses(2), (3)				57,904			48,655			1,310			107,869

	Operating (loss) income			(12,991	)		10,977			(1,310	)		(3,324	)
Interest and other expense, net				—			—			675			675

	(Loss) income before taxes and extraordinary gain			(12,991	)		10,977			(1,985	)		(3,999	)
Income tax benefit				—			—			1,360			1,360

	Net (loss) income before extraordinary gain			(12,991	)		10,977			(625	)		(2,639	)
Extraordinary gain(4)				450			—			(153	)		297

	Net (loss) income			(12,541	)		10,977			(778	)		(2,342	)
Depreciation and amortization				3,025			1,029			97			4,151
Net changes in working capital and other				10,610			(1,714	)		(935	)		7,961

		Net cash provided by (used for) operations	$	1,094		$	10,292		$	(1,616	)	$	9,770

(1): Discounts provided to Preferred Buyers' Club® and Insiders® members are allocated entirely to Catalog Retail and totaled $285,000 and $3.1 million in the three months ended and $1.1 million and $6.3 million during the six months ended July 1, 2000 and July 3, 1999, respectively.
(2): Includes inter-segment charge from Catalog Retail to Membership Services of $5.6 million for the three months ended and $10.8 million for the six months ended July 3, 1999. In conjunction with the wind-down of the Catalog Retail business, these costs are no longer being incurred.
(3): Corporate expenses for the three and six months ended July 3, 1999 include a pre-tax charge of $1.3 million for the implementation of a revised vacation and sick time policy. The corporate charge includes $300,000 which was previously recorded by the Catalog Retail and Membership Services segments and transferred to the Corporate segment during the second quarter of 1999.
(4): Relates to a condemnation of land. See Note 7.

Selected balance sheet data by business segment is as follows:

		Catalog Retail			Membership Services			Corporate		Consolidated
		(Amounts in thousands)
At July 1, 2000
Cash and cash equivalents		$	9		$	—		$	440	$	449
Non-cash current assets			(5,866	)		49,669			21,626		65,429
Net property, equipment and other assets			21,850			1,760			23,105		46,715

	Total assets	$	15,993		$	51,429		$	45,171	$	112,593

Non-interest bearing current liabilities		$	13,985		$	90,874		$	—	$	104,859
Short-term borrowings			—			—			11,543		11,543
Investment in segment/shareholders' equity (deficit)			2,008			(39,445	)		33,628		(3,809	)

	Total liabilities and equity	$	15,993		$	51,429		$	45,171	$	112,593

At December 31, 1999
Cash and cash equivalents		$	—		$	—		$	3,927	$	3,927
Non-cash current assets			52,933			36,406			3,159		92,498
Net property, equipment and other assets			20,273			5,331			4,017		29,621

	Total assets	$	73,206		$	41,737		$	11,103	$	126,046

Non-interest bearing current liabilities		$	32,046		$	62,330		$	2,253	$	96,629
Investment in segment/shareholders' equity (deficit)			41,160			(20,593	)		8,850		29,417

	Total liabilities and equity	$	73,206		$	41,737		$	11,103	$	126,046

Note 7. Extraordinary Gain

During the second quarter of 1999, the State of Minnesota condemned and acquired approximately 17 acres of land from the Company in conjunction with a highway expansion project. As a result, the Company recorded an extraordinary gain of $297,000, net of taxes, or $.05 per share.

Note 8. Legal Matters

On October 25, 1996, a current Preferred Buyers' Club® member commenced an action against the Company in a New Jersey state court. This action was styled on his behalf and on behalf of a class of the Company's customers, each of which is a member of the Company's Preferred Buyers' Club®. The plaintiff alleges that he and the other members of the proposed class have not received their full anticipated benefits as Preferred Buyers' Club® members. The complaint alleges various violations of state consumer fraud and contract law and seeks compensatory and punitive damages. Discovery has been completed. The court has denied a motion for an injunctive or damages class certification on a national basis and has granted a certification for a damages class consisting of Preferred Buyers' Club® members in New Jersey alone. The case is scheduled for trial in the fall of 2000. The Company believes it has factual and legal defenses and is defending the action aggressively. Discovery has been completed and management believes that the resolution of this action will not have a material adverse effect on the financial condition or results of operations of the Company.

Note 9. Subsequent Event

At July 1, 2000 the Company had a revolving line of credit and letter of credit facility that had been used for general working capital and other corporate purposes. On July 28, 2000, the Company replaced this revolving line of credit with a new $15 million commercial credit facility which reduces to $10 million on January 1, 2001. The facility is available for working capital and general corporate needs and contains a $2 million sublimit to accommodate the issuance of standby letters of credit. Borrowings outstanding under the new line of credit bear interest at the reference rate of interest plus 0.5% or LIBOR plus 3.25% and are secured by all assets of the Company. The credit facility includes covenants which require the Company to satisfy certain financial tests and ratios on a monthly basis and limits the downstreaming of funds to ClickShip to $8.0 million.

Note 10. Recently Issued Accounting Pronouncement

SFAS No. 133, "Accounting for Derivative Investments and Hedging Activities", establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS No. 133 will be effective for the Company beginning January 1, 2001. Management believes the adoption of SFAS No. 133 will not have a material impact on the Company's financial position or results of operations.

DAMARK INTERNATIONAL, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

Results of Operations

The data presented below are derived from the Company's consolidated financial statements and notes thereto and should be read in conjunction therewith. The Company operates in two business segments, Membership Services and Catalog Retail. These reportable operating segments offer different products and services and are managed separately based on fundamental differences in their operations. A Corporate segment is also used to account for taxes, capital allocation and certain unallocated items.

			Three months ended								Six months ended
			July 1, 2000			July 3, 1999			% change		July 1, 2000			July 3, 1999			% change
Statement of Operations Data:
Net revenues:
	Catalog Retail(1)		$	17,729		$	77,692		(77.2	)%	$	57,112		$	162,042		(64.8	)%
	Membership Services			34,044			34,554		(1.5	)%		70,183			59,632		17.7	%

		Total		51,773			112,246		(53.9	)%		27,295			221,674		(42.6	)%
Costs and expenses:
	Catalog Retail cost of products sold			16,680			55,558		(70.0	)%		48,496			117,129		(58.6	)%
	Catalog Retail expenses(2)			22,785			30,229		(24.6	)%		53,458			57,904		(7.7	)%
	Restructuring charges			2,259			—		N/A			8,998			—		N/A
	Membership Services expenses(2)			24,414			27,401		(10.9	)%		49,983			48,655		1.1	%
	Corporate expenses			—			1,310		N/A			—			1,310		N/A

		Total		66,138			114,498		(42.2	)%		160,135			224,998		(28.8	)%

Operating (loss) income:
	Catalog Retail			(23,995	)		(8,095	)	(196.4	)%		(53,840	)		(12,991	)	(314.4	)%
	Membership Services			9,630			7,153		34.6	%		21,000			10,977		91.3	%
	Corporate			—			(1,310	)	N/A			—			(1,310	)	N/A

		Total		(14,365	)		(2,252	)	(537.9	)%		(32,840	)		(3,324	)	(888.0	)%
Interest expense, net				280			255		9.8	%		478			544		(12.1	)%
Other expense, net				31			119		(73.9	)%		160			131		22.1	%

	Loss before income taxes and other			(14,676	)		(2,626	)	(458.9	)%		(33,478	)		(3,999	)	(737.2	)%
Income tax benefit				5,858			893		556.0	%		12,700			1,360		833.8	%

	Net loss before extraordinary gain and cumulative effect			(8,818	)		(1,733	)	(408.8	)%		(20,778	)		(2,639	)	(687.3	)%
Extraordinary gain, net of taxes				—			297		N/A			—			297		N/A
Cumulative effect of accounting change, net of taxes				—			—		N/A			(14,201	)		—		N/A

	Net loss		$	(8,818	)	$	(1,436	)	(514.1	)%	$	(34,979	)		(2,342	)	(1,393.6	)%

Statement of Cash Flows Data:
Net cash (used for) provided by operations:
	Catalog Retail(2)		$	(496	)	$	2,070		(124.0	)%		(10,452	)	$	1,094		(1,055.4	)%
	Membership Services(2)			10,017			12,944		(22.6	)%		13,757			10,292		33.7	%
	Corporate			(7,374	)		(1,444	)	(410.7	)%		(19,129	)		(1,616	)	(1,083.7	)%

		Total	$	2,147		$	13,570		(84.2	)%	$	(15,824	)	$	9,770		(262.0	)%

(1): Discounts provided to the Preferred Buyers Club® and Insiders® members are allocated entirely to Catalog Retail and totaled $285,000 and $3.1 million for the three months ended and $1.1 million and $6.3 million for the six months ended July 1, 2000 and July 3, 1999, respectively.
(2): Includes inter-segment charge from Catalog Retail to Membership Services of $5.7 million for the three months ended and $10.8 million for the six months ended July 3, 1999. In conjunction with the wind-down of the Catalog Retail business, these costs are no longer being incurred.

General

In January 2000, the Company announced that it would wind-down its non-member catalog marketing and merchandising activities. Going forward, catalog mailings will be limited to members of the Company's shopping clubs. The wind-down was substantially completed by the end of second quarter 2000, at which time the Company discontinued taking catalog orders from non-member customers. The Company will continue to operate its membership services business which recently started doing business as Provell. The order capture, product fulfillment and customer service capabilities developed by the Company were redeployed into a subsidiary named ClickShip Direct, Inc. ("ClickShip"), that was formed in January 2000. The Company currently plans to separate ClickShip as an independent, publicly traded company through a distribution of shares to the Company's shareholders during the third or fourth quarter of 2000.

Provell will continue to develop, market, and manage membership programs that provide purchase price discounts and other benefits related to consumer and small business needs in areas of shopping, travel, hospitality, entertainment, health/fitness and finance. Arrangements have been made with third parties to supply the members of the Company's shopping clubs with benefits at least equal to those formerly provided by the Company's catalog operations. A dedicated management team sources products available on a direct-from-supplier basis, avoiding the need to own, store, and fulfill inventory from a Company-owned location. Provell also outsources teleservices orders and customer service with carefully selected telemarketing providers, including ClickShip.

ClickShip provides outsourcing of order fulfillment and customer care services to retailers, direct marketers, and manufacturers. Services include online and offline order-capture, payment processing, inventory receipt, warehousing, merchandise shipment, after-the-sale customer service and support and returns management.

In conjunction with the restructuring of the Company's catalog operations, the Company's Brooklyn Center, Minnesota telemarketing center was closed in January 2000. Approximately 150 jobs were eliminated as part of the restructuring, primarily in catalog marketing, merchandising and the telemarketing center. As a result of these activities, the Company recorded a pre-tax restructuring charge of $9.0 million during the first half of 2000. Included in the charge is approximately $1.3 million related to employee severance and termination benefits (with no remaining balance to be paid at July 1, 2000), $1.9 million for future lease and other minimum commitments with no future benefit and $5.8 million for accelerated depreciation expense as a result of changes in the estimated useful lives of fixed assets that will only be used during certain transition periods. During the third and fourth quarters of 2000, the Company expects to record an additional $200,000 to $400,000 of incremental depreciation expense as an additional component of the restructuring charge.

Membership Services

This segment's results reflect the adoption of SAB 101 effective January 1, 2000. Prior to the adoption of SAB 101, membership revenues with respect to clubs for which the Company had an ongoing obligation were recorded on the balance sheet, net of direct solicitation costs, and amortized into income over the membership period, generally twelve months. Revenues and related expenses on clubs for which the Company had no significant ongoing obligation were recognized immediately, net of an accrual for future anticipated returns, once any trial period had elapsed. Effective January 1, 2000, the Company defers the recognition of revenues and direct solicitation costs on all membership programs and amortizes such revenues and costs, after the trial period has elapsed, over the membership period, generally twelve months. The Company also defers the recognition of costs and revenues associated with extended warranty service contracts until the end of the return period, generally three months. Previously, extended warranty revenues and costs were recognized immediately.

The Company recorded a non-cash charge of $22.9 million ($14.2 million net of taxes) related to the adoption of SAB 101. See Note 2 to the Consolidated Financial Statements.

The Company has been able to maintain its membership base by accelerating its member prospecting, and replacing its member acquisition leads which have been lost due to the wind-down of its catalog retail business. Provell's expanded client roster now includes several of the nation's largest financial institutions, as well as a number of premier consumer marketing organizations. The Company's membership base has increased from 1.9 million members at the end of the second quarter of 1999 to 2.2 million members at the end of the second quarter of 2000.

Membership revenues were $34.0 million for second quarter 2000, a 1.5% decrease from second quarter 1999 revenues. Revenues for the six months ended July 1, 2000 were $70.2 million, a 17.7% increase over the prior year comparable period. Second quarter operating income increased 34.6% to $9.6 million in 2000 as compared to $7.2 million in 1999. First half 2000 operating income increased 91.3% to $21 million as compared to $11.0 million in 1999. On a pro forma basis, assuming SAB 101 had been adopted retroactively, second quarter 1999 membership revenues and operating income would have been $31.7 million and $7.8 million, respectively. For the half, 1999 membership revenues and operating income would have been $45.6 million and $1.1 million, respectively. Operating income for 1999 reflects a charge of $5.7 million and $10.8 million for the quarter and first half, respectively, for commissions to the Catalog Retail segment. In conjunction with the catalog wind-down, these costs are no longer being incurred. The exclusion of the inter-segment charge in 2000 and lower than anticipated operating costs accompanied by an increase in the Company's membership base, expanded membership club offerings and club price increases each contributed to the revenue and operating income growth during the first half of 2000.

Costs and expenses incurred by the Company's Membership Services segment include direct membership solicitation costs, payments to external vendors to provide certain club benefits, customer service costs, commissions and success fees paid to clients for use of their customer lists and general and administrative expenses, and in 1999, inter-segment charges from the Catalog Retail segment (see above discussion).

Segment costs and expenses decreased 10.9% for the second quarter in comparison to second quarter 1999 and remained relatively consistent for first half 2000 in comparison to first half 1999 with a 1.1% increase. Costs and expenses as a percentage of net revenues decreased to 71.7% in second quarter 2000 as compared to 79.3% in second quarter 1999. First half costs and expenses as a percentage of net revenues were 70.0% in 2000 as compared to 81.6% in 1999. The decrease in costs and expenses was due primarily to the inter-segment charges included in costs and expenses in 1999 (see above discussion). The company has also benefited from improved leveraging of costs over a larger membership and revenue base and increased revenues from membership renewals. Profitability from renewal memberships exceeds that of new membership acquisitions due to the absence of membership solicitation costs associated with renewals.

Catalog Retail

The wind-down of the Company's non-member Catalog Retail operations was substantially completed during the second quarter. As of July 1, 2000 the Company is no longer taking non-member catalog orders but will continue to process customer returns and further liquidate inventories. During the second quarter of 2000, the Company continued to mail catalogs slotted with product on hand and used other liquidation means to substantially reduce inventory levels. The wind-down of Catalog Retail activities and related liquidations resulted in substantially lower revenues during the second quarter and first half of 2000 in comparison to 1999. This segment generated revenues of $17.7 million and $57.1 million during the second quarter and first half of 2000, respectively, a decrease of 77.2% and 64.8% from revenues of $77.7 million and $162.0 million generated during the second quarter and first

half of 1999, respectively. Revenues generated from Catalog wind-down activities totaled $17.2 million and $56.1 million for the second quarter and first half, respectively, while ClickShip generated $9.6 million and $18.0 million of revenues during the second quarter and first half, respectively. Included in ClickShip's second quarter revenues were approximately $6.8 million of revenues from services provided to its parent, Damark, for activities related to the winding down of non-member and member catalog activities and $2.3 million of revenues pursuant to an agreement entered into to provide ongoing customer care services to Provell's members. ClickShip's first half revenues included $13.6 million from Provell non-member catalog wind-down activities and $3.4 million from ongoing Provell customer care activities. Catalog Retail wind-down activities generated gross product margins of 5.9% in the second quarter of 2000 as compared to 28.5% in second quarter 1999 and 15.1% for the first half of 2000 as compared to 27.7% for the first half of 1999. The 2000 margin percentages were negatively impacted by liquidation activities associated with the catalog wind-down. The segment reported a net loss of $24.0 million in second quarter 2000 and $53.9 million for the first half of 2000 as compared to a net loss of $8.1 million in second quarter 1999 and $12.5 million for the first half of 1999.

Operating expenses as a percentage of segment net revenues increased to 128.5% in second quarter 2000 from 38.9% in second quarter 1999. For the six month period ended July 1, 2000, operating expenses were 93.6% of net revenues as compared to 35.7% for the comparable period in the prior year. The increase was due primarily to a decrease in advertising leverage as advertising costs were leveraged against significantly reduced revenue levels as a result of the Company's efforts to liquidate its inventory levels. In addition, the second quarter and first half 1999 expenses included inter-segment transfers of costs from the Catalog Retail segment to the Membership Services segment of $5.7 million and $10.8 million, respectively (see previous discussion).

Corporate

Corporate expenses for the three and six months ended July 3, 1999 include a pre-tax charge of $1.3 million for the implementation of a revised vacation and sick time policy. The charge includes $300,000 which was previously recorded by the Catalog Retail and Membership Services segments and transferred to the Corporate segment during second quarter 1999.

The Company incurred interest expense of $280,000 and $255,000 during the second quarter of 2000 and 1999, respectively. Interest expense of $478,000 and $544,000 was incurred during the first half of 2000 and 1999, respectively. Declines in installment receivable and inventory balances in 2000 as compared to 1999 borrowing levels were partially offset by the need for increased borrowings to fund the wind-down of the Company's non-member catalog operations and ClickShip start up costs.

The Company's effective tax rate was 39.9% for second quarter 2000 and 37.9% for the first six months of 2000 as compared to 34.0% for the second quarter and first half of 1999. The increase in the effective tax rate is the result of additional state income taxes associated with the restructuring of the Company's operations. Despite incurring net losses in recent quarters, the Company has not recorded a deferred tax valuation allowance since management believes that its operating and tax planning strategies will allow the Company to generate sufficient income in early future years in order to realize this asset. Should the Company's operating and tax planning strategies fail to produce sufficient taxable income in early future years, the Company will record a valuation allowance for all or a portion of its net deferred tax asset as required by generally accepted accounting principles.

Extraordinary Gain

The State of Minnesota condemned and acquired approximately 17 acres of land from the Company in conjunction with a highway expansion project. As a result, the Company recorded an extraordinary gain of $297,000, net of taxes, or $.05 per share during the second quarter of 1999.

Liquidity and Capital Resources

Cash Flow

Net cash used for operations totaled $15.8 million for the first half of 2000 as compared to net cash provided by operations of $9.8 million for the same period in 1999. The increase in cash used for operations in 2000 was the result of an increased net loss in 2000 due primarily to the wind-down activities in the Catalog Retail segment. Cash generated by working capital changes was $9.0 million in 2000 as compared to $9.5 million in 1999. Declines in inventory and receivable balances partially offset by declines in current liability balances contributed to the cash generated by working capital changes in 2000 and 1999.

Capital Expenditures

During the first half of 2000, the Company's capital expenditures were approximately $7.1 milion, compared to $2.2 million during 1999. During the balance of 2000, capital expenditures will continue to be made to support the activities and infrastructure of ClickShip, and to enhance Provell's infrastructure and operational efficiencies. The Company is in the process of expanding its distribution facility by 320,000 square feet at an approximate cost of $12 million ($2.3 million had been funded as of July 1, 2000) in order to meet the increased capacity needs anticipated for ClickShip. Management estimates that an additional $7 million in infrastructure enhancements will be invested for ClickShip during 2000. Management also estimates that $6 million to $8 million will be invested in the Membership Services business during 2000, consisting of $1 million to $2 million for leasehold improvements and furniture for a new corporate headquarters and an additional $5 million to $6 million for systems development and infrastructure enhancements.

Financing

At July 1, 2000 the Company had a revolving line of credit and letter of credit facility that had been used for general working capital and other corporate purposes. On July 28, 2000, the Company replaced the revolving line of credit with a new $15 million commercial credit facility which reduces to $10 million on January 1, 2001. The facility is available for working capital and general corporate needs and contains a $2 million sublimit to accommodate the issuance of standby letters of credit. Borrowings outstanding under the under the line of credit bear interest at the reference rate of interest plus 0.5% or LIBOR plus 3.25% and are secured by all assets of the Company. The credit facility includes covenants which require the Company to satisfy certain financial tests and ratios on a monthly basis and limits the downstreaming of funds to ClickShip to $8.0 million.

ClickShip is actively working to procure at least $20 million of mortgage proceeds to fund its distribution center expansion, other capital expenditures and operations. Management expects to complete an agreement in September or October 2000. In addition, additional financing needs are anticipated to fund ClickShip's operations. If such financing is not obtained, the Company will need to defer further capital expansion or other planned business expansion activities.

Assuming the above financing is obtained, the Company anticipates that cash generated from operations, and available borrowing capacity under the new credit facility will be sufficient to fund its operations and Provell capital expenditures for the remainder of 2000.

Stock Repurchases

Seasonality

Like most retailing businesses, the Company's Catalog Retail segment was subject to significant seasonal variations in consumer demand. Historically, the Company's net retail revenues were the highest during the fourth quarter and a significant portion of its earnings were realized during that period. The Company's annual operating results were affected by holiday spending patterns, as well as the timing and effectiveness of catalog mailings and general economic and other conditions. Because the wind-down of the non-member catalog operations is complete, management expects the seasonal variations in consumer demand to have a less significant impact on the Company's membership business while fourth quarter consumer demand will continue to have a significant impact on ClickShip's business.

Inflation

Excluding increases in postage and paper costs, inflation has not had, and the Company does not expect it to have, a material impact on operating results. There can be no assurances, however, that the Company's business will not be affected by inflation in the future.

Forward-Looking Information

Certain of the matters discussed herein are "forward-looking statements" intended to qualify for the safe harbor provisions from liability provided by the Private Securities Litigation Reform Act of 1995. Important factors exist that could cause results to differ materially from those anticipated by some of the statements herein. In addition to statements that are forward-looking by reason of context, the words "believe", "expect", "anticipate", "intend", "designed", "goal", "priority", "will" and similar expressions identify forward-looking statements. Investors are cautioned that all forward-looking statements involve risks and uncertainties which could cause actual results to differ materially from expectations, including those identified below:

•: Availability of capital on acceptable terms;
•: The economic outlook and its effects on credit availability, interest rates, and consumer spending patterns;
•: Adverse changes in relationships with vendors and partners who provide club benefits;
•: Inability to develop replacement shopping club programs;
•: Lower than expected membership renewal rates;
•: Higher than expected membership cancellation and return rates;
•: Excessive new member acquisition costs;
•: Inability to retain existing clients and attract new clients in the membership services market;
•: Inability to develop new membership programs;
•: Inability to attract clients in the fulfillment market;
•: Reliance on fees generated by potentially volatile transaction volume or product sales of its fulfillment clients;
•: Effects of possible system failures and rapid changes in technology;
•: Inability of the Company's systems or infrastructure to accommodate significant growth in its fulfillment business;
•: Changes in the trend toward outsourcing;

•: Externally mandated changes in accounting guidelines; and
•: Trends in government regulation;

Shareholders, potential investors and other readers are urged to consider these and other factors in evaluating the forward-looking statements made herein, all of which speak only as of the date on which they are made and as to which the Company has no obligation to update publicly.

Part II. Other Information

Item 1. Legal Proceedings

On October 25, 1996, a current Preferred Buyers' Club® member commenced an action against the Company in a New Jersey state court. This action was styled on his behalf and on behalf of a class of the Company customers, each of which are members of the Company's Preferred Buyers' Club®. The plaintiff alleges that he and the other members of the proposed class have not received their full anticipated benefits as Preferred Buyers' Club® members. The complaint alleges various violations of state consumer fraud and contract law and seeks compensatory and punitive damages. The court has preliminarily denied a motion for an injunctive or damages class certification on a national basis and has preliminarily granted a certification for a damages class consisting of Preferred Buyers' Club® members in New Jersey alone. The case is scheduled for trial in the fall of 2000. Discovery has been completed and the Company believes that the resolution of this action will not have a material adverse effect on the financial condition or results of operations of the Company.

Item 6. Exhibits and Reports on Form 8-K

a.: Exhibits:

Exhibit 10—Credit Agreement, dated as of July 28, 2000 by and between Registrant and Bank of America, N.A.

Exhibit 27—Financial Data Schedule

b.: Reports on Form 8-K:

The registrant did not file any reports on Form 8-K during the quarter ended July 1, 2000.

Signature

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.

		DAMARK INTERNATIONAL, INC.
Date: August 15, 2000		By:		/s/ STEPHEN P. LETAK Stephen P. Letak Executive Vice President— Chief Financial Officer

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DAMARK INTERNATIONAL, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Part II. Other Information
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