<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTER ENDED
JUNE 30, 1998
[ ] 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 0-21894
SOURCE MEDIA, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 13-3700438
(STATE OF INCORPORATION) (I.R.S. EMPLOYER
IDENTIFICATION NUMBER)
5400 LBJ FREEWAY, SUITE 680
DALLAS, TEXAS 75240
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(972) 701-5400
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
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 SUCH FILING
REQUIREMENTS FOR THE PAST 90 DAYS.
YES X NO
--- ---
NUMBER OF SHARES OF COMMON STOCK OUTSTANDING AT AUGUST 11, 1998: 12,601,847
--------- ----------
<PAGE> 2
SOURCE MEDIA, INC.
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 1998
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION
Page Number
Item 1. Consolidated Financial Statements -----------
<S> <C>
Consolidated Balance Sheets (Unaudited)
June 30, 1998 and December 31, 1997 3-4
Consolidated Statements of Operations (Unaudited)
Three months ended June 30, 1998 and 1997 5
Consolidated Statements of Cash Flows (Unaudited)
Three months ended June 30, 1998 and 1997 6
Notes to Consolidated Financial Statements 7-13
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 14-20
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 21-22
Item 2. Changes in Securities N/A
Item 3. Defaults Upon Senior Securities N/A
Item 4. Submission of Matters to a Vote of Securities Holders N/A
Item 5. Other Information N/A
Item 6. Exhibits and Reports on Form 8-K 22-23
</TABLE>
2
<PAGE> 3
PART I - FINANCIAL INFORMATION
SOURCE MEDIA, INC.
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
<TABLE>
<CAPTION>
DEC. 31, JUNE 30,
1997 1998
------------ -----------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 8,430,941 $14,250,694
Short-term investments 15,615,419 2,322,243
Restricted investments 11,709,921 11,663,902
Trade accounts receivable, less allowance
for doubtful accounts of $153,694 and $348,364
in 1997 and 1998, respectively 2,796,241 4,704,882
Deferred expenses 990,687 937,179
Prepaid expenses and other current assets 843,005 924,482
------------ -----------
Total current assets 40,386,214 34,803,382
Property and equipment:
Production equipment 5,693,939 5,783,840
Computer equipment 2,652,103 3,085,016
Other equipment 753,883 1,035,732
Furniture and fixtures 523,516 631,807
------------ -----------
9,623,441 10,536,395
Accumulated depreciation 4,193,484 5,445,432
------------ -----------
Net property and equipment 5,429,957 5,090,963
Intangible assets:
Patents 14,942,465 14,944,242
Goodwill 22,372,837 6,698,137
Contract rights 24,487,000 11,933,377
------------ -----------
61,802,302 33,575,756
Accumulated amortization 10,528,869 12,083,702
------------ -----------
Net intangible assets 51,273,433 21,492,054
Restricted investments 11,090,574 5,649,134
Other non-current assets 5,321,848 5,058,659
------------ -----------
Total assets $113,502,026 $72,094,192
============ ===========
</TABLE>
3
<PAGE> 4
SOURCE MEDIA, INC.
CONSOLIDATED BALANCE SHEETS (CONTINUED)
(UNAUDITED)
<TABLE>
<CAPTION>
DEC. 31, JUNE 30,
1997 1998
------------- -------------
<S> <C> <C>
LIABILITIES AND STOCKHOLDERS' EQUITY (CAPITAL DEFICIENCY)
Current liabilities:
Trade accounts payable $ 1,654,404 $ 1,191,705
Accrued interest 2,066,667 2,000,000
Accrued payroll 150,062 279,618
Other accrued liabilities 1,205,541 1,599,539
Unearned income 4,024,164 3,842,172
------------- -------------
Total current liabilities 9,100,838 8,913,034
Long-term debt 100,000,000 100,000,000
Capital lease obligations, less current portion 20,884 15,508
Minority interests in consolidated subsidiaries 3,839,552 3,839,552
Note receivable and accrued interest from minority
stockholder, net of discount of $95,437 and
$74,580 in 1997 and 1998, respectively (723,645) (751,940)
------------- -------------
3,115,907 3,087,612
Senior redeemable payment-in-kind (PIK) preferred stock,
$25 liquidation preference, $.001 par value, net of
discount
Authorized shares - 1,000,000, Issued shares - 800,000
and 854,911 in 1997 and 1998, respectively 13,696,799 15,248,904
Stockholders' equity (capital deficiency):
Common stock, $.001 par value:
Authorized shares - 50,000,000
Issued shares - 11,969,039 and 12,058,626 in 1997
and 1998, respectively 11,969 12,059
Less treasury stock, at cost - 410,963 and 374,980 in 1997
and 1998, respectively (4,075,127) (3,705,676)
Capital in excess of par value 81,482,951 82,263,342
Accumulated deficit (89,729,242) (133,664,842)
Foreign currency translation (23,760) (743)
Notes receivable and accrued interest
from stockholders (99,193) (75,006)
------------- -------------
Total stockholders' equity (capital deficiency) (12,432,402) (55,170,866)
------------- -------------
Total liabilities and stockholders' equity (capital deficiency) $ 113,502,026 $ 72,094,192
============= =============
</TABLE>
See accompanying notes.
4
<PAGE> 5
SOURCE MEDIA, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
1997 1998 1997 1998
------------ ------------ ------------ -----------
<S> <C> <C> <C> <C>
Monetary revenues $ 2,707,153 $ 5,800,535 $ 5,336,008 10,991,442
Nonmonetary revenues 1,723,237 $ 438,434 3,410,757 1,113,001
------------ ----------- ------------ -----------
Total revenues 4,430,390 $ 6,238,969 8,746,765 12,104,443
Monetary cost of sales 1,550,775 $ 2,998,726 2,901,810 5,303,961
Nonmonetary cost of sales 1,723,237 $ 438,434 3,410,757 1,113,001
------------ ----------- ------------ -----------
Total cost of sales 3,274,012 $ 3,437,160 6,312,567 6,416,962
------------ ----------- ------------ -----------
Gross profit 1,156,378 $ 2,801,809 2,434,198 5,687,481
Selling, general and administrative expenses 4,501,510 $ 5,965,259 9,074,492 11,583,729
Impairment of intangibles assets -- $ 25,935,715 -- 25,935,715
Amortization of intangible assets 1,018,740 $ 1,226,219 1,843,612 3,847,441
Research and development expenses 1,065,554 $ 694,883 1,844,467 1,447,997
------------ ----------- ------------ -----------
6,585,804 $ 33,822,076 12,762,571 42,814,882
------------ ----------- ------------ -----------
Operating loss (5,429,426) (31,020,267) (10,328,373) (37,127,401)
Interest expense 772,848 3,168,618 980,375 6,409,354
Interest income (103,070) (512,915) (155,249) (1,141,260)
Other (income) expense (43,650) (19,279) (49,644) (39,920)
Minority interest in losses of consolidated subsidiaries 0 0 (8,970)
------------ ----------- ------------ -----------
626,128 2,636,424 766,512 5,228,174
------------ ----------- ------------ -----------
Net loss $ (6,055,554) (33,656,691) $(11,094,885) (42,355,575)
============ =========== ============ ===========
Preferred stock dividends 814,068 1,580,025
Net Loss attributable to common stockholders (6,055,554) (34,470,759) (11,094,885) (43,935,600)
============ =========== ============ ===========
Basic and diluted net loss per common share $ (0.53) $ (2.97) $ (0.99) $ (3.79)
============ =========== ============ ===========
Weighted average common shares outstanding 11,336,092 11,604,030 11,220,586 11,587,954
============ =========== ============ ===========
</TABLE>
See accompanying notes.
5
<PAGE> 6
SOURCE MEDIA, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
UNAUDITED
<TABLE>
<CAPTION>
SIX MONTHS ENDED JUNE 30,
1997 1998
------------ ------------
<S> <C> <C>
OPERATING ACTIVITIES
Net loss $(11,094,885) (42,355,575)
Adjustments to reconcile net loss to net cash used in
operating activities:
Impairment of intangible assets -- 25,935,715
Depreciation 1,038,309 1,251,948
Amortization of intangible assets 1,843,612 3,847,441
Deferred compensation -- 670,330
Non-cash interest expense 966,227 402,789
Non-cash interest income -- (579,208)
Provision for losses on accounts receivable -- (194,670)
Write-off of debt issue costs 315,068 --
Warrants issued for services provided 279,571 --
Minority interest in net earnings (losses) (8,970) --
Other, net (22,775) (30,775)
Changes in operating assets and liabilities:
Trade accounts receivable (349,464) (1,713,971)
Prepaid expenses and other assets 364,456 (81,477)
Deferred expenses (70,815) 53,508
Trade accounts payable and accrued liabilities 55,419 683
Unearned income (798,202) (181,992)
------------ ------------
Net cash used in operating activities (7,482,449) (12,975,254)
INVESTING ACTIVITIES
Capital expenditures (1,452,188) (912,954)
Acquisition of equipment and contract rights (600,000) --
Redemption of short-term investments -- 19,359,843
------------ ------------
Net cash provided by (used in) investing activities (2,052,188) 18,446,889
FINANCING ACTIVITIES
Proceeds from issuance of long-term debt 13,922,625 --
Proceeds from issuance of common stock upon exercise
of stock options 121,523 479,602
Payments on capital lease obligations (74,682) --
Payment of fees and expenses associated with the financing -- (167,520)
Other (67,237) 13,019
------------ ------------
Net cash provided by financing activities 13,902,229 325,101
Effect of exchange rate changes on cash and cash equivalents (44,007) 23,017
------------ ------------
Net decrease in cash and cash equivalents 4,323,585 5,819,753
Cash and cash equivalents at beginning of period 4,302,943 8,430,941
------------ ------------
Cash and cash equivalents at end of period $ 8,626,528 $ 14,250,694
============ ============
</TABLE>
See accompanying notes.
6
<PAGE> 7
SOURCE MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Unless the context otherwise requires, (a) all references to the "Company" or
"Source" include Source Media, Inc. and its wholly-owned subsidiaries, SMI
Holdings, Inc. ("Holdings"), IT Network, Inc. ("IT Network"), Interactive
Channel, Inc. ("Interactive Channel"), and Interactive Channel Technologies,
Inc., marketed under the name of VirtualModem ("ICT" which was formerly known as
Cableshare, Inc.), and (b) all references to the Company's activities, results
of operations or financial condition prior to June 23, 1995 relate to Holdings.
1. Basis of Presentation
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and the instructions for Form 10-Q and Article 10 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 these financial statements
include all adjustments, consisting of normal recurring accruals, necessary to
present fairly the financial position, results of operations and cash flows of
Source Media, Inc. and its consolidated subsidiaries for the periods indicated.
The balance sheet at December 31, 1997, has been derived from the audited
financial statements at that date. For further information, refer to the
consolidated financial statements and notes thereto included in the Company's
Annual Report on Form 10-K for the year ended December 31, 1997.
2. Net Loss Per Common Share
For the three and six month periods ended June 30, 1998, in accordance
with the requirements of Statement of Financial Accounting Standards ("SFAS")
No. 128, "Earnings Per Share", net loss per common share amounts ("basic EPS")
were computed by dividing net loss attributable to common stockholders by the
weighted average number of common shares outstanding. A diluted earnings per
share has not been presented because the options and warrants are anti-dilutive.
Net loss per share amounts for the same prior-year period do not differ from the
amounts previously disclosed due to the anti-dilutive nature of the stock
options and warrants.
3. Contingencies
On December 15, 1993, Marvin Lerch, the former Chief Executive Officer
and a former shareholder of ICT and certain of his relatives, who are also
former ICT shareholders, commenced a legal proceeding in Ontario, Canada in the
Ontario Court (General Division) against the Company and certain executive
officers of the Company and a former director of ICT on the grounds that the
defendants took actions intended to depress the value of ICT to allow the
Company to acquire shares of ICT at a favorable price. The plaintiffs seek,
among other things, orders that certain actions by ICT's board were invalid; a
declaration that ICT's board was incapable of managing its affairs due to
conflicts of interest; an injunction against the Company from voting its ICT
shares for three years, purchase by the defendants of the plaintiffs' ICT
7
<PAGE> 8
shares for Cdn$20 per share or exchange of the plaintiffs' ICT shares for common
shares of the Company of equal value; and damages in the amount of Cdn$8 million
to compensate the plaintiffs for the reduced value of their ICT shares and
damages in the amount of Cdn$6 million to compensate Mr. Lerch for the loss of
certain ICT stock options. ICT disputes all of the claims, and no trial date has
as yet been set. The plaintiffs have amended their statement of claim to assert
a claim for punitive damages in the amounts of Cdn$1 million against the Company
and an aggregate of Cdn$2 million against certain officers of the Company. The
statement of claim was also amended on August 12, 1997, to add ICT as a
defendant. Although the ultimate outcome of this action cannot be determined at
this time, management believes the claims are without merit and intends to
vigorously defend its position. In addition, management believes the ultimate
outcome of these actions will not have a material impact on the consolidated
financial condition or results of operations of the Company.
On January 25, 1994, Mr. Lerch also commenced a proceeding against ICT
and several persons who are, or have been, officers and directors of ICT
claiming wrongful termination of Mr. Lerch's employment with ICT and seeking
damages in the amount of Cdn$350,000. ICT denied the claim. At the trial of this
action in London, Ontario in spring 1996, judgment was rendered against ICT in
the amount of Cdn$200,000. ICT's appeal of this decision was initially denied
and ICT has applied for a review of this decision before a three judge panel,
which granted the Company leave to appeal the decision. A hearing on the
Company's appeal is scheduled for October 7, 1998, and the Court's decision may
not be issued for at least six months.
On May 11, 1998, ICT and SMI Holdings, Inc., both wholly-owned
subsidiaries of Source, filed an action in U.S. District Court for the District
of Delaware against WorldGate Communications, Inc. ("WorldGate") alleging that
WorldGate has infringed four of the Company's patents. The litigation is in
the very preliminary stages. However, the Company intends to aggressively defend
its patents.
The Company has instituted and is involved in certain litigation in
federal and state courts related to copyright infringement, tortious
interference and violations of non-compete agreements signed by former employees
of IT Network, Inc. In addition, the Company is aware of certain claims against
the Company and ICT that have not developed into litigation, or if they have,
are dormant. Further, the Company and ICT are parties to ordinary routine
litigation incidental to their business, none of which is expected to have a
material adverse effect on the Company's results of operations or financial
condition.
4. Acquisitions
In January 1997, the Company acquired all of the outstanding shares of
ICT held by minority interest shareholders in exchange for approximately
1,390,000 shares of the Company's common stock, making ICT a wholly-owned
subsidiary of the Company. The Company also issued options to purchase 177,000
shares of the Company's common stock at exercise prices ranging from $1.43 to
$4.96 per share to certain employees and directors of ICT in exchange for their
outstanding options to purchase ICT common shares, and incurred cash expenses
related to the acquisition of approximately $675,000. The aggregate purchase
price for the acquisition of
8
<PAGE> 9
the ICT minority interest was approximately $11.2 million, and the acquisition
was accounted for by the purchase method of accounting. The purchase price was
allocated primarily to patents, which are being amortized over a five year
period.
On October 30, 1997, the Company acquired certain of the electronic
publishing assets of Brite Voice Systems, Inc. ("Brite") for a purchase price of
approximately $35.6 million. The Brite acquisition has been accounted for by the
purchase method of accounting and the purchase price was allocated to equipment,
contract rights and goodwill based on the estimated fair values of the assets at
the date of acquisition. See Note 5 related to subsequent impairment of the
assets acquired.
Also on October 30, 1997, the Company acquired certain of the assets of
Voice News Network, Inc. ("VNN"), a subsidiary of Tribune Media Services a unit
of Tribune Company, for a purchase price of $9.0 million. The VNN acquisition
has been accounted for by the purchase method of accounting and the purchase
price was allocated to equipment, contract rights and goodwill based on the
estimated fair values of the assets at the date of acquisition.
The following represents the unaudited pro forma results of operations
as if the above acquisitions had occurred on January 1, 1997, after giving
effect to certain adjustments, including interest expense, preferred stock
dividends, and amortization of intangibles resulting from the allocation of the
purchase price.
<TABLE>
<CAPTION>
Six Months Ended
June 30, 1997
-------------
(In thousands, except
per share amount)
<S> <C>
Total revenues $ 16,464
Gross margin 6,225
Operating loss (10,995)
Net loss attributable to common stockholders $(18,458)
Net loss per common share $ (1.63)
</TABLE>
The pro forma results given above are not necessarily indicative of
what actually would have occurred if the acquisition had been in effect during
the period presented, and is not intended to be a projection of future results
or trends.
5. Impairment
The carrying value of intangible assets is reviewed for impairment
whenever events or changes in circumstances indicate that there may be
impairment. If the review indicates that any of the intangibles will not be
recoverable, as determined by an analysis of undiscounted cash flows, the
intangible asset will be reduced to its estimated recoverable value. Subsequent
to the Brite acquisition, the Company learned that former Brite and IT Network
employees had formed a third company to service many of these former Brite
clients. The Company has reviewed the valuation of the acquired assets recorded
at the time of the acquisition, and has found these assets to have been
impaired. As a result of financial analysis of the expected discounted future
cash flows of the remaining customer base, the Company has recorded a $25.9
million ($2.24 per share) non-cash write-down of the Brite contract rights,
non-compete agreement and goodwill.
9
<PAGE> 10
6. Long-Term Debt and Notes Payable
On April 3, 1996, the Company issued a senior note (the "First Tranche
Note") in the principal amount of $5.0 million and a warrant (the "First Tranche
Warrant") which entitled the holder thereof to purchase 500,000 shares of the
Company's common stock at a purchase price of $10.21 per share. On September 30,
1996 and March 31, 1997, the Company issued additional senior notes in the
amounts of $326,806 and $350,090, respectively, for the payment of interest on
the First Tranche Note. The First Tranche Note and the additional senior notes
(collectively, the "Aggregate First Tranche Notes") were due on March 31, 2001,
and bore interest at the rate of 13% per annum through March 31, 1998, and 12%
thereafter. The estimated fair market value at the date of issuance of the First
Tranche Warrant of $745,830 was credited to capital in excess of par value and
the First Tranche Note was recorded at a corresponding discount. The discount on
the First Tranche Note was being amortized to interest expense using the
effective interest rate method over the stated term of the First Tranche Note,
resulting in an effective interest rate of 16.2%.
On April 9, 1997, the Company received cash proceeds of $15.0 million
upon the issuance of additional senior notes (the "Second Tranche Notes") in the
principal amount of $15.0 million and warrants (the "Second Tranche Warrants")
which entitled the holders thereof to purchase in the aggregate 2,000,000 shares
of the Company's common stock at a purchase price of $6.00 per share at any time
until their expiration on March 31, 2004. The estimated fair market value of the
Second Tranche Warrants of $1.7 million at the date of issuance was credited to
capital in excess of par value and the Second Tranche Notes were recorded at a
corresponding discount. The discount on the Second Tranche Notes was being
amortized to interest expense using the effective interest rate method over the
stated terms of the Second Tranche Notes resulting in an effective interest rate
of 15.4%. Additionally, in connection with the issuance of the Second Tranche
Notes and the Second Tranche Warrants, the Aggregate First Tranche Notes and the
First Tranche Warrant were amended and restated to terms identical to those of
the Second Tranche Notes and the Second Tranche Warrants, respectively. The
amended Aggregate First Tranche Notes and the Second Tranche Notes were due on
March 31, 2002, and bore interest at the rate of either: (i) 12% per annum
through March 31, 1999, if paid in cash, or (ii) 13% per annum through March 31,
1999, if paid through the issuance of additional notes, and 12% thereafter. On
September 30, 1997, the interest due on the Aggregate First Tranche Notes and
the Second Tranche Notes was paid through the issuance of additional notes, with
terms identical to those of the Second Tranche Notes, in the amount of
approximately $1.3 million and warrants to purchase approximately 165,000 shares
of common stock. The estimated fair market values of the notes and warrants
issued in lieu of a cash interest payment on September 30, 1997, were
approximately $1.1 million and $1.1 million, respectively, which were recorded
as interest expense during 1997.
The amendment of the Aggregate First Tranche Notes and First Tranche
Warrant was accounted for as the extinguishment and replacement of the existing
senior notes and the cancellation of the existing warrants and issuance of new
warrants due to the significance of the modification to the terms of the senior
notes and warrants. The extinguishment resulted in a loss of approximately
$315,000, which was included in other (income) expense during the second quarter
of 1997.
10
<PAGE> 11
On October 30, 1997, the Company issued senior secured notes (the
"Senior Secured Notes" or the "Notes") in the principal amount of $100 million,
which bear interest at the rate of 12% per annum through November 1, 2004.
Interest on the Notes is payable semi-annually on May 1 and November 1 of each
year commencing on May 1, 1998, to holders of record at the close of business on
April 15th or October 15th immediately preceding the interest payment date. The
Company placed approximately $22.6 million of the net proceeds from the
offering, representing funds sufficient, together with interest thereon, to pay
the first four interest payments on the Notes, into an escrow account.
In connection with the issuance of the Senior Secured Notes, the
Company used $22.2 million of the proceeds received to pay off the amended
Aggregate First Tranche Notes and the Second Tranche Notes, including accrued
interest thereon, and the notes issued on September 30, 1997, in lieu of a cash
interest payment. The early extinguishment of these notes resulted in a charge
to earnings of approximately $3.5 million related to unamortized discount on the
Second Tranche Notes and unamortized issuance costs which were recorded as an
extraordinary item in the fourth quarter of 1997. The proceeds were also used to
complete the Company's acquisitions of certain assets more fully described in
Note 4 - Acquisitions.
The Notes are fully and unconditionally guaranteed, jointly and
severally, by each of the Company's subsidiaries (the "Subsidiary Guarantors").
The guarantees are senior obligations of the Subsidiary Guarantors and are
secured by substantially all of the assets of the Subsidiary Guarantors. The
guarantees rank pari passu in right of payment with all existing and future
senior indebtedness of the Subsidiary Guarantors and rank senior in right of
payment to all existing and future subordinated obligations of the Subsidiary
Guarantors. The guarantees may be released upon the occurrence of certain
events. The guarantee executed by IT Network contains a covenant that restricts
payments of dividends on its capital stock to an amount sufficient to cover debt
service on the Notes, redemptions or repurchases of the Notes or the Preferred
Stock, dividends on the Preferred Stock, and corporate overhead. The assets of
the Subsidiary Guarantors are not restricted as to the redemption of the Notes
or Preferred Stock or payment of the interest or dividends thereon. The assets
of the parent, Source Media, Inc., consist solely of investments in its
subsidiaries and invested proceeds from the Senior Secured Notes and the
Preferred Stock and related warrants. Financial statements for the Subsidiary
Guarantors and Source are not presented because management has determined that
they would not be material to investors.
Except as described below, the Company may not redeem the Notes prior
to November 1, 2001. On or after such date, the Company may redeem the Notes, in
whole or in part, at any time, at various redemption prices set forth in the
indenture governing the sale of the Notes, together with accrued and unpaid
interest, if any, to the date of redemption. In addition, at any time and from
time to time on or prior to November 1, 2000, the Company may, subject to
certain requirements, redeem up to 35% of the aggregate principal amount of the
Notes with the cash proceeds of one or more equity offerings at a redemption
price equal to 112% of the principal amount to be redeemed, together with
accrued and unpaid interest, if any, to the date of redemption, provided, that,
at least $65 million of the aggregate principal amount of the Notes remain
outstanding immediately after each such redemption. The Notes are not subject to
any sinking fund requirement. Upon the occurrence of a change in control, the
Company will be
11
<PAGE> 12
required to make an offer to repurchase the Notes at a price equal to 101% of
the principal amount thereof, together with accrued and unpaid interest, if any,
to the date of the repurchase. The indenture contains certain covenants
including, but not limited to, limitations on indebtedness, restricted payments,
liens, restrictions on distributions from restricted subsidiaries, sales of
assets and subsidiary stock, affiliate transactions, issuances of capital stock
of restricted subsidiaries and sale/leaseback transactions.
7. Senior PIK Preferred Stock
On October 30, 1997, the Company received cash proceeds of $20.0
million upon the issuance of 800 units (the "Units"). Each Unit consisting of
1,000 shares of non-voting Senior PIK Preferred Stock (the "Preferred Stock")
with a liquidation preference of $25.00 per share and 558.75 warrants (the
"October 1997 Warrants") to purchase one share of the Company's common stock at
a purchase price of $0.01 per share. In the aggregate, the October 1997 Warrants
represent the right to purchase 447,000 shares of common stock. The Units were
sold in connection with the Company's acquisitions of certain of the assets more
fully described in Note 4 - Acquisitions.
Dividends on the Preferred Stock are payable quarterly on each February
1, May 1, August 1 and November 1 at an annual rate of 13 1/2% of the
liquidation preference per share. Dividends may be paid, at the Company's
option, on any dividend payment date occurring on or prior to November 1, 2002,
either in cash or by the issuance of additional shares of Preferred Stock with a
liquidation preference equal to the amount of such dividends; thereafter,
dividends will be paid in cash. The indenture governing the sale of the Senior
Secured Notes limits the amount of cash dividends that may be paid on the
Preferred Stock. At any time and from time to time on or prior to November 1,
2000, the Company may, subject to certain requirements, redeem up to 35% of the
aggregate liquidation value of the Preferred Stock with the cash proceeds of one
or more equity offerings at a redemption price equal to the liquidation
preference thereof, plus accumulated dividends, on the date of redemption. After
November 1, 2000, and prior to November 1, 2002, the Preferred Stock is not
redeemable. On or after November 1, 2002, the Company may redeem the Preferred
Stock, in whole or in part, at any time, at various redemption prices, plus
accumulated and unpaid dividends, to the date of redemption. Upon the occurrence
of a change in control, the Company will be required to make an offer to
purchase the outstanding shares of the Preferred Stock at a price equal to 101%
of the liquidation preference thereof, plus accumulated and unpaid dividends, to
the date of purchase. The Preferred Stock will be subject to mandatory
redemption in whole on November 1, 2007, at a price equal to 100% of the then
effective liquidation preference thereof, plus, without duplication, all accrued
and unpaid dividends to the date of redemption. The certificate of designation
contains certain covenants including, but not limited to, limitations on
indebtedness, restricted payments, affiliate transactions, issuances of capital
stock of restricted subsidiaries and sale/leaseback transactions.
The Preferred Stock ranks senior to all classes of common stock and to
each other class of capital stock or series of preferred stock with respect to
dividend rights and rights on liquidation, winding-up and dissolution of the
Company. The Preferred Stock is non-voting except in certain circumstances. The
Company may not authorize any new class of preferred stock that ranks senior or
pari passu to the Preferred Stock without the approval of the holders of at
least a
12
<PAGE> 13
majority of the shares of Preferred Stock then outstanding, voting or
consenting, as the case may be, as one class, provided, however, that the
Company can issue additional shares of Preferred Stock to satisfy dividend
payments on outstanding shares of Preferred Stock; and provided further,
however, that the Company can issue shares of preferred stock ranking pari passu
with the Preferred Stock if after giving effect thereto, the Consolidated
Coverage Ratio, as defined in the certificate of designations, is greater than
1.7 to 1.0.
The estimated fair market value of the October 1997 Warrants, which was
estimated to be approximately $5.5 million was credited to capital in excess of
par value and the Preferred Stock was recorded at a corresponding discount. The
Preferred Stock was recorded net of $1.2 million of issuance costs and the
discount on the Preferred Stock which are being accreted as additional Preferred
Stock dividends using the effective interest rate method over a ten year period,
resulting in an effective dividend rate of 19.3%.
On February 1, and May 1, 1998, the quarterly dividends due on the
Preferred Stock were paid through the issuance of additional Preferred Stock
having a liquidation preference of $675,000 and $698,000 respectively, with
terms identical to those of the Preferred Stock. The estimated fair market value
of the stock issued in lieu of a cash interest payment on February 1, and May 1,
1998, was approximately $488,000 and $698,000, which were recorded as preferred
stock dividends.
8. Stock Compensation
On January 2, 1998, the Company granted stock options to employees. The
options fully vest on January 2, 2004. If certain target stock prices are met,
the vesting accelerates. As a portion of the underlying shares for these options
had not been authorized by the shareholders at the date of grant, the portion of
unauthorized options were treated as a variable compensation plan through July
28, 1998, when the shareholders authorized the shares. As a result of this
accounting treatment, the Company has recognized non-cash expense in selling,
general, and administrative expenses of $437,000 and $670,000 for the three and
six month periods ended June 30, 1998, respectively.
13
<PAGE> 14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Unless the context otherwise requires, all references to the "Company" or
"Source" include Source Media, Inc. and its wholly-owned subsidiaries, SMI
Holdings, Inc. ("Holdings"), IT Network, Inc. ("IT Network"), Interactive
Channel, Inc. ("Interactive Channel"), and Interactive Channel Technologies,
Inc., marketed under the name of VirtualModem ("ICT" which was formerly known as
Cableshare, Inc.).
FORWARD LOOKING INFORMATION AND RISK FACTORS
The Company or its representatives may make forward looking statements,
oral or written, including statements in this report's Management's Discussion
and Analysis of Financial Condition and Results of Operations, press releases
and filings with the Securities and Exchange Commission about confidence and
strategies and plans and expectations about demand, demand and acceptance of new
and existing products, potential acquisitions, potential for profits and returns
on investments in products and markets that are forward looking statements
involving risks and uncertainties that could significantly impact the Company.
Although the Company believes that the expectations reflected in these forward
looking statements are reasonable, there can be no assurance that the actual
results or developments anticipated by the Company will be realized or, even if
substantially realized, that they will have the expected effects on its business
or operations. Among the factors that could cause actual results to differ
materially from the Company's expectations are its ability to secure
distribution for Cable SuperSites; delays in the deployment of digital set-top
boxes; failure to make available advanced analog or digital set-top boxes
incorporating the Company's technology; ability to successfully integrate,
retain and grow the acquired customer base into existing operations; general
economic and business conditions; industry trends; competition; equipment costs
and availability; terms and deployment of capital; availability of qualified
personnel; changes in, or the failure to comply with, government regulation; and
other factors discussed from time to time in the Company's Annual Report on Form
10-K and other Securities and Exchange Commission filings.
GENERAL
Source provides on-demand information, services and programming through
the telephone and can provide such information services and programming through
cable television over the Company's proprietary digital operating systems
through its two operating subsidiaries, IT Network and Interactive Channel. IT
Network's products and services are available through Yellow Pages to over 100
million households, offices and hotel rooms in North America and the Caribbean
and through inserts in daily newspapers with an aggregate circulation of over 24
million. Interactive Channel can provide on-demand information and services and
Internet access to the cable television industry over existing cable
infrastructure and telephone lines, with the addition of an advanced analog or a
digital set-top box.
IT Network provides voice information services through telephone
directories and newspapers and also provides related support services to certain
Yellow Pages directory and newspaper publishers participating with the Company
in offering voice information services
14
<PAGE> 15
("Publisher Partners"). The Company sells advertising, both print and audiotex,
primarily to local advertisers in the markets it serves. Additionally, it
provides a variety of support services related to advertising clients including
inbound and outbound customer service, producing and delivering audio content
and system management of audiotex systems. Advertising clients pay to sponsor
and deliver a promotional message before and after the delivery of the voice
information. The Company provides voice information services to 8 of the 10
largest Yellow Pages directory publishers in the country.
Interactive Channel's Cable SuperSites Network ("Cable SuperSites") can
supply programming and services allowing a subscriber to access on-demand local
and national news, weather, sports and school information, view programming
guides and purchase goods and can allow a subscriber to browse the Internet,
send and receive e-mail and access a variety of other offerings over existing
cable infrastructure and telephone lines, with the addition of an advanced
analog or digital set-top box. Cable SuperSites can allow the Company or cable
system operators to sell interactive advertising space on cable screens using
text, voice and pictures. Cable SuperSites can be broadcast by cable operators
utilizing the Company's proprietary two-way operating system, SourceWare.
SourceWare can enable any cable television system equipped with a compatible
advanced analog or digital set-top box to deliver two-way, on-demand programming
with the touch of a remote control. In less than one second, Cable SuperSites
can allow subscribers to access interactive programming delivered over the cable
system to their television.
IT Network earns monetary revenues through advertising sponsorships and
services provided to certain Regional Bell Operating Companies or their
affiliates or other Yellow Pages publishers (collectively, Directory
Publishers). Monetary revenues and associated costs relating to print ads
appearing in Yellow Pages are recognized at the time of distribution by the
Directory Publishers. For certain contracts, where an obligation exists to
service the advertisement for the contract period, a portion of the revenue is
deferred and amortized on a straight-line basis over the term of the respective
contracts, beginning at the time of the annual distribution of the applicable
local Yellow Pages directory, or at the applicable contract start date, if
later, and continuing to the end of the term of the respective contracts, which
is typically from 3 to 12 months. The Company also earns monetary revenues from
sales of voice information services to certain Publisher Partners. The Company
is earning a significant percentage of its monetary revenues by acting as a
sales agent for advertising in directories published by Publisher Partners and
providing voice information services in those directories. Monetary revenues
relating to non-Yellow Pages products are recognized as the services performed.
The Company has entered into nonmonetary barter agreements with local
television and radio stations. These media sponsors provide the Company with
advertising time on their stations and update local news, weather and sports
voice information messages in exchange for promotional messages and print
advertisements in the Network Guide. Revenues and cost of sales associated with
these nonmonetary barter transactions are included in the Company's consolidated
statements of operations at the estimated fair value of the on-air
advertisements and information content provided to the Company by media
sponsors. The Company expects that nonmonetary revenues as a percentage of total
revenues will continue to decline in the future as the Company earns a higher
percentage of its revenues as a service provider or sales agent rather than from
sales of advertising in the Network Guide.
On October 30, 1997, the Company purchased certain of the electronic
publishing assets of Brite for $35.6 million and certain of the assets of VNN, a
unit of Tribune Company, for $9.0 million. Recently, a significant portion of
the customer contracts purchased in the Brite acquisition have been cancelled or
not renewed. As a result, the Company has reviewed the value assigned to the
contract rights and certain related intangible assets acquired in the Brite
purchase and has found them, along with a pro-rata portion of the related
goodwill associated with the Brite acquisition, to be impaired, resulting in a
write-off of $25.9 million in the second quarter of 1998.
15
<PAGE> 16
On April 24, 1998, The Company announced that its Board of Directors
adopted a Shareholder Rights Plan and declared a dividend distribution of one
Common Share Purchase Right on each outstanding share of the Company's Common
Stock. The dividend distribution was made on May 7, 1998, payable to
shareholders of record on that date. Under the Rights Plan, each shareholder
will be entitled to buy one share of the Company's Common Stock at an exercise
price of $65.00. The Rights will become exercisable following the tenth day
after a person or group announces acquisition of 15% or more of the Company's
Common Stock or the tenth business day after a person or group announces
commencement of a tender offer which would result in such an acquisition.
Subject to certain restrictions, the Company will be entitled to redeem the
Rights at $0.001 per Right at any time before they become exercisable. The
rights will expire on May 7, 2008. Generally, if a person or group acquires 15%
or more of the Company's Common Stock, the Rights will entitle shareholders
(other than the acquiror) to purchase shares of Common Stock of the Company (or,
in certain circumstances, cash, other property or other securities) at half the
then-current market price. In addition, if, after the acquisition by a person or
group of 15% or more of the Company's Common Stock, Source Media sells more than
50% of its assets or earning power or is acquired in a merger or other business
combination transaction, the acquiror must assume the obligations under the
Rights and the Rights will become exercisable to acquire Common Stock of the
acquiror at the discounted price.
HIGHLIGHTS OF SECOND QUARTER RESULTS
During the second quarter of 1998, the Company experienced several
important events and continued its investment in its future growth and
profitability. These events include (i) a significant loss of revenue associated
with the purchase of certain assets from Brite Voice; (ii) the industry loss of
the Galaxy IV satellite; and (iii) a continued investment in the growth of our
sales force. Each of these events has had an impact on second quarter results.
On October 30, 1997, the Company completed the purchase of certain
assets from Brite Voice to consolidate the Company's position as the leader in
the audiotex industry. As a result, revenue, cost of sales, operating costs,
depreciation and amortization have increased significantly. During the first
quarter of 1998, the Company experienced much higher than anticipated
transition costs in servicing the former Brite clients. The Company
subsequently learned that former Brite and IT Network employees had formed a
third company to service many of these former Brite clients. The Company has
reviewed the valuation of acquired assets recorded at the time of the
acquisition, and has found these assets to have been impaired. As a result of
financial analysis of the expected discounted future cash flows of the
remaining customer base, the Company has recorded a $25.9 million ($2.24 per
share) non-cash write-down of the Brite contract rights, non-compete agreement
and goodwill. The Company has instituted and is involved in certain litigations
in federal and state court related to non-compete agreements signed by former
employees of IT Network.
On May 20, 1998, the Galaxy IV satellite lost navigational capability
and ceased effective communications operations. IT Network had approximately
25% of its affiliate links on Galaxy IV, and was forced to set-up an emergency
distribution system using dial-up LAN lines to update affiliate networks. The
Company then had to purchase capacity on another satellite (Galaxy 3-R) and
reposition approximately 200 antennaes to the new orbit. The direct cost of
this effort was approximately $0.3 million ($0.03 per share).
16
<PAGE> 17
The Company continues to invest in the expansion of its sales force.
From the first of the year, the Company has increased its sales force from 15 to
50 sales people in the second quarter. The Company has experienced record
bookings and intends to continue its aggressive sales force growth.
SIX MONTHS ENDED JUNE 30, 1998 AND 1997
Monetary revenues increased 106% from $5.3 million to $11.0 million due
to the acquisitions of Brite and VNN, which provided additional service revenue
growth of 173%, or a $4.0 million increase from $2.3 million to $6.3 million.
Advertising sales grew 63% to $4.6 million. This growth can be attributed to
internal growth in the Company's client base as well as the acquisition of
Brite in fourth quarter of 1997. In addition, the Company has entered into
certain new advertiser agreements which earned approximately $0.8 million in
revenue for the period. Under the new advertiser agreement, revenue from print
advertising is earned at the time of the directory distribution, while revenue
for services agreements and prior advertising agreements is earned and
recognized over the term of the contract. Unearned income will become less
significant in future periods as less revenue is deferred under the new
contracts.
Monetary costs of sales increased 83% from $2.9 million to $5.3
million. IT Network's cost of sales increased from $1.8 million to $4.5 million,
while the Company's television initiatives cost of sales decreased from $1.0
million to $0.7 million. This increase was due to increased costs associated
with increased revenue, transition costs associated with the acquisitions as
well as the direct and indirect expenses associated with the total failure of
the Galaxy IV satellite.
Nonmonetary revenue and costs of sales decreased by 67% from $3.4
million to $1.1 million as the Company continues to reduce its volume of barter
contracts. Nonmonetary revenue now represents only 9% of total revenue compared
with approximately 39% of total revenue in the prior period.
The net result of this activity is that the Company's total revenue
increased 38% (from $8.7 million to $12.1 million) while total gross margin
increased 134% (from $2.4 million to $5.7 million).
Selling, general and administrative expenses increased from $9.1
million to $11.6 million. This net increase resulted from (i) an increase of
$3.2 million to sell and support new services and advertising contracts acquired
from Brite and VNN (ii) a decrease of $1.9 million in television related
expenses due to the discontinuation of the Colorado Springs trial (iii) a $0.5
million increase in corporate legal and other expenses associated with patent
related activity and the consolidation of Brite's Wichita facility.
Additionally, due to the increase in the Company's stock price since January 2,
1998, the portion of the employee stock options granted on such date, which were
subject to shareholder approval at the annual meeting held on July 28, 1998, are
accounted for as a variable option plan resulting in non-cash compensation
expense which is recognized over the vesting period. Non-cash compensation
expense increased to $0.7 million for the period ended June 30, 1998, from $0.0
million in 1997. The Company expects to recognize additional expense of $1.1
million and $543,000 for the third and fourth quarters of, respectively.
Impairment of Intangible Assets. An adjustment of $25.9 million was
made to reflect the impairment of certain contract rights, non-compete
agreements and goodwill associated with the Brite purchase.
Research and development expenses declined 21% from $1.8 million to
$1.4 million as the Company discontinued the development of analog products and
focused on the design and development of its digital interactive television
technologies.
17
<PAGE> 18
Interest expense, interest income. Interest expense increased $5.4
million from $1.0 million to $6.4 million. This expense is associated with a
$100 million debt financing completed by the Company in October 1997 and
described in detail in the Footnotes to the Financial Statements. Interest
income increased $0.9 million from $0.2 million to $1.1 million due to an
increased cash balance from the funding of operating losses.
Preferred stock dividends. PIK preferred stock dividends of $1.6
million for the period ended June 30, 1998, was related to a $20 million PIK
preferred stock financing completed by the Company in October 1997.
Cash Position. The Company has $33.9 million in cash, cash equivalents
or restricted investments. Of this amount, $16.6 million is available to fund
operations with the remaining $17.3 million held in escrow to fund debt service
through November 1999. The Company's first cash debt payment to be funded from
non-escrowed capital is due in May 2000.
THREE MONTHS ENDED JUNE 30, 1998 AND 1997
Monetary revenues increased 114% from $2.7 million to $5.8 million due
to the acquisitions of Brite and VNN, which provided additional service revenue
of approximately $2.3 million. Advertising sales grew 20% to $1.7 million.
Monetary costs of sales increased from $1.6 million to $3.0 million
with the doubling of revenue. IT Network's cost of sales increased from $1.0
million to $2.8 million, while the Company's television initiatives cost of
sales decreased from $0.6 million to $0.2 million. With the cable industry
accelerating its deployment plans for digital set-tops, the Company has focused
its resources on digital products and has scaled back its analog projects
including discontinuing the Colorado Springs trial which has helped to improve
monetary gross margins from 43% to 48%.
Nonmonetary revenue and costs of sales was reduced by 75% from
$1.7 million to $0.4 million as the Company continues to reduce its volume of
barter contracts. Nonmonetary revenue now reflects only 7% of total revenue
compared with approximately 39% of total revenue in the prior period.
The net result of this activity is that the Company's total revenue
increased 41% (from $4.4 million to $6.2 million) while total gross margin
increased 142% (from $1.2 million to $2.8 million).
Selling, general and administrative expenses increased from $4.5
million to $6.0 million. This net increase resulted from (i) an increase of $1.2
million through increased sales, marketing, and administrative expenses incurred
by IT Network to support increased sales, new services and advertising contracts
acquired from Brite and VNN as well as new markets, (ii) a $0.5 million increase
in legal and other expenses associated with patent related activity, and the
Brite acquisition issues, (iii) a $0.4 million non-cash expense associated with
the variable plan accounting for a stock option grant, (iv) decreases of certain
personnel salaries, subscriber acquisition, travel and other Cable SuperSites
expenses. Due to the increase in the Company's stock price since January 2,
1998, the portion of the employee stock options granted on such date, which were
subject to shareholder approval at the annual meeting held on July 28, 1998, are
accounted for as a variable option plan resulting in non-cash compensation
expense which is recognized over the vesting period.
18
<PAGE> 19
Impairment of Intangible Assets. An adjustment of $25.9 million was
made to reflect the impairment of certain contract rights, non-compete
agreements and goodwill associated with the Brite purchase.
Research and development expenses were reduced from $1.1 million to
$0.7 million as the Company streamlined its efforts to focus on the digital
design and development of its interactive television technologies.
Interest expense, interest income. Interest expense increased from $0.8
million to $3.2 million. This increase is due to a higher debt balance
associated with a $100 million debt financing completed by the Company in
October 1997. Interest income increased $0.4 million due to interest earned on
the proceeds from the debt and preferred stock offerings.
Preferred stock dividends. PIK preferred stock dividends of $0.8
million for the quarter ended June 30, 1998, was related to a $20 million PIK
preferred stock financing completed by the Company in October 1997.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has experienced substantial operating
losses and net losses as a result of its efforts to (i) develop, deploy and
support IT Network, (ii) acquire a controlling interest in ICT, and (iii)
develop, conduct trials and commercially launch Cable SuperSites. As of June 30,
1998, the Company had an accumulated deficit of approximately $133.7 million and
had used cumulative net cash in operations of $65.6 million. The difference at
June 30, 1998, between the accumulated deficit and cumulative net cash used in
operations since inception was attributable primarily to nonmonetary charges
related to financing incentives and extinguishment of debt, write-down of analog
set-top boxes and intangible assets, depreciation and amortization and other
non-cash expenses. As a result of the October 1997 Brite and VNN Acquisitions,
the Company has experienced growth in its revenues, gross margins, and operating
expenses. However, the effect of the lost customers associated with the Brite
acquisition will continue to have a negative impact on the Company's revenues
and profitability. The Company will continue to incur operating losses at least
through 1998, although it expects that cash used in IT Network operations will
decline as a result of other growth initiatives. The launch of the Company's
television products and services may require additional expenditures.
Since its inception, the Company has financed its operations primarily
through an aggregate $156.6 million raised from various financing activities,
including the incurrence of debt and issuance of the Company's common stock and
preferred stock. In October 1997, the Company issued $100.0 million of its
Senior Secured Notes and $20.0 million of its Senior PIK Preferred Stock. The
interest escrow account created pursuant to the Indenture will be used to fund
the first four interest payments on the Senior Secured Notes. The first interest
payment from the interest escrow account was made on May 1, 1998. The Company's
primary source of liquidity is its cash, cash equivalents and short-term
investments, which totaled $33.9 million at June 30, 1998. This cash position
consists of $17.3 million held in escrow for debt payments, and $16.6 million of
operating cash. The Company's first debt payment not currently held in escrow is
due May 1, 2000.
The Company currently believes its resources will be sufficient to meet
the Company's anticipated
19
<PAGE> 20
cash needs for working capital and other capital expenditures related to the
further development of Cable SuperSites and IT Network into the fourth quarter
of 1999.
The Company's future capital requirements will depend on many factors,
including, but not limited to the following factors, some of which are outside
the Company's control: (i) the operating results of IT Network, including the
Company's ability to successfully integrate its acquired businesses into its
existing business, and to retain and grow its customer base, (ii) the success
and timing of the development, introduction and deployment of Cable SuperSites,
(iii) the extent to which the Company is able to generate revenues from
licensing its proprietary technology, (iv) the number of file servers and other
equipment which the Company purchases in support of Cable SuperSites, (v) the
levels of advertising expenditures necessary to increase awareness of Cable
SuperSites, (vi) the extent of market acceptance of such products, (vii)
potential acquisitions or asset purchases, (viii) the deployment of digital
set-top boxes incorporating the Company's technology, and (ix) competitive
factors.
YEAR 2000 DISCLOSURE
Year 2000. The Company has completed an initial review of the potential
impact of the year 2000 on the processing of date-sensitive information by the
Company's computerized information and support systems. The year 2000 problem is
the result of software that uses two digits (rather than four) to define the
applicable year. Any software or hardware that utilizes date-sensitive coding
may recognize a date using "00" as the year 1900 rather than the year 2000,
which could result in miscalculations or system failures. As a result of its
review, a formal plan for addressing the potential impact of the year 2000
problem on the Company's operations has been developed. This plan outlines a
series of projects focused on identifying and eradicating potential year 2000
problems. Included in this plan are efforts to address potential problems with
the Company's customers and vendors. There can be no assurance that the
Company's efforts to solve its potential year 2000 problems will be successful,
or even partially successful. If the Company, its customers or vendors are
unable to adequately resolve the year 2000 problem, it could have a material
adverse impact on the Company's financial position, results of operations, or
cash flows in future periods. Because the resources available to address the
year 2000 problem are scarce, to the extent the Company identifies problems that
require the services of third parties, it will most likely incur significant
expenses in its attempts to address such problems, if it is able to obtain such
services at all.
NET OPERATING LOSS CARRYFORWARDS
At December 31, 1997, Holdings had net operating loss carryforwards of
approximately $60.9 million for U.S. Federal income tax purposes, which begin to
expire in 2003. The Internal Revenue Code of 1986, as amended, imposes
limitations on the use of net operating loss carryforwards if certain stock
ownership changes occur. Consequently, the Company's utilization of pre-1996 net
operating losses is limited to approximately $9.0 million in a given year.
20
<PAGE> 21
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings
Lerch. On December 15, 1993, Marvin Lerch, the former Chief Executive
Officer and a former shareholder of ICT and certain of his relatives, who were
also former ICT shareholders, commenced a legal proceeding in Ontario, Canada in
the Ontario Court (General Division) against the Company and certain executive
officers of the Company and a former director of ICT on the grounds that the
defendants took actions intended to depress the value of ICT to allow the
Company to acquire shares of ICT at a favorable price. The plaintiffs seek,
among other things, orders that certain actions by ICT's board were invalid; a
declaration that ICT's board was incapable of managing its affairs due to
conflicts of interest; an injunction against the Company voting its ICT shares
for three years; purchase by the defendants of the plaintiffs' ICT shares for
Cdn$20 per share or exchange of the plaintiffs' ICT shares for common shares of
the Company of equal value; and damages in the amount of Cdn$8 million to
compensate the plaintiffs for the reduced value of their ICT shares and damages
in the amount of Cdn$6 million to compensate Mr. Lerch for the loss of certain
ICT stock options. ICT disputes all of the claims, and no trial date has as yet
been set. The plaintiffs have amended their statement of claim to assert a claim
for punitive damages in the amounts of Cdn$1 million against the Company and an
aggregate of Cdn$2 million against certain officers of the Company. The
statement of claim was also amended on August 12, 1997, to add ICT as a
defendant. Although the ultimate outcome of this action cannot be determined at
this time, management believes the claims are without merit and intends to
vigorously defend its position. In addition, management believes the ultimate
outcome of these actions will not have a material impact on the consolidated
financial condition or results of operations of the Company.
On January 25, 1994, Mr. Lerch also commenced a proceeding against ICT
and several persons who are, or have been, officers and directors of ICT
claiming wrongful termination of Mr. Lerch's employment with ICT and seeking
damages in the amount of Cdn$350,000. ICT denied the claim. At the trial of this
action in London, Ontario in spring 1996, judgment was rendered against ICT in
the amount of Cdn$200,000. ICT's appeal of this decision was initially denied
and ICT has applied for a review of this decision before a three judge panel,
which granted the Company leave to appeal the decision. A hearing on the
Company's appeal is scheduled for October 7, 1998, and the Court's decision may
not be issued for at least six months.
On May 11, 1998, ICT and SMI Holdings, Inc., both wholly-owned
subsidiaries of Source, filed an action in U.S. District Court for the District
of Delaware against WorldGate Communications, Inc. ("WorldGate") alleging that
WorldGate has infringed four of the Company's patents relating to internet
access over the existing cable system infrastructure. The litigation is in the
very preliminary stages. However, the Company intends to aggressively defend its
patents.
21
<PAGE> 22
Others. The Company has instituted and is involved in certain litigation
in federal and state courts related to copyright infringement, tortious
interference and violations of non-compete agreements signed by former employees
of IT Network, Inc. In addition, the Company is aware of certain claims against
the Company and ICT that have not developed into litigation, or if they have,
are dormant. Further, the Company and ICT are parties to ordinary routine
litigation incidental to their business, none of which is expected to have a
material adverse effect on the Company's results of operations or financial
condition.
Item 2 - Changes in Securities - not applicable
Item 3 - Defaults Upon Senior Securities - not applicable
Item 4 - Submission of Matters to a Vote of Security Holders - not applicable
Item 5 - Other information - not applicable
Item 6 - Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 27 - Financial Data Schedule
(b) Reports on Form 8-K during the three months ended
June 30, 1998 - not applicable
22
<PAGE> 23
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.
SOURCE MEDIA, INC.
(Registrant)
Date: August 14, 1998 By: /s/ PAUL TIGH
---------------------------
Paul Tigh
Chief Financial Officer and
Treasurer
(Principal Financial Officer
and Duly Authorized Officer)
23
<PAGE> 24
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
------ -----------
27 Financial Data Schedule
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 14,250,694
<SECURITIES> 2,322,243
<RECEIVABLES> 4,704,882
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 34,803,382
<PP&E> 10,536,395
<DEPRECIATION> 5,445,432
<TOTAL-ASSETS> 72,094,192
<CURRENT-LIABILITIES> 8,913,034
<BONDS> 100,000,000
15,248,904
0
<COMMON> 12,059
<OTHER-SE> 55,170,866
<TOTAL-LIABILITY-AND-EQUITY> 72,094,192
<SALES> 12,104,443
<TOTAL-REVENUES> 12,104,443
<CGS> 6,416,962
<TOTAL-COSTS> 42,814,882
<OTHER-EXPENSES> (1,181,180)
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 6,409,354
<INCOME-PRETAX> 42,355,575
<INCOME-TAX> 0
<INCOME-CONTINUING> 42,355,575
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 43,935,500
<EPS-PRIMARY> (3.79)
<EPS-DILUTED> (3.79)
</TABLE>
