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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED
SEPTEMBER 30, 1999
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)
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 NOVEMBER 10, 1999: 13,666,292
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SOURCE MEDIA, INC.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 1999
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION
Page Number
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<S> <C> <C>
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets (Unaudited)
DECEMBER 31, 1998 and SEPTEMBER 30, 1999 3-4
Consolidated Statements of Operations (Unaudited)
Three and nine month periods ended SEPTEMBER 30, 1998 AND 1999 5
Consolidated Statements of Cash Flows (Unaudited)
Nine months ended SEPTEMBER 30, 1998 AND 1999 6
Notes to Consolidated Financial Statements (Unaudited) 7-15
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 16-23
Item 3. Quantitative and Qualitative Disclosures About Market Risk 23
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 24-26
Item 2. Changes in Securities and Use of Proceeds N/A
Item 3. Defaults Upon Senior Securities N/A
Item 4. Submission of Matters to a Vote of Security Holders N/A
Item 5. Other Information 26-28
Item 6. Exhibits and Reports on Form 8-K 28
</TABLE>
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PART I - FINANCIAL INFORMATION
SOURCE MEDIA, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
DECEMBER 31, SEPTEMBER 30,
1998 1999
------------ -------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $11,662 $ 5,768
Restricted investments 11,716 6,011
Trade accounts receivable, less allowance
for doubtful accounts of $387 and $742
in 1998 and 1999, respectively 3,596 1,491
Deferred expenses 447 501
Prepaid expenses and other current assets 937 996
------- -------
Total current assets 28,358 14,767
Property and equipment:
Production equipment 6,050 6,776
Computer equipment 3,273 3,467
Other equipment 1,150 1,401
Furniture and fixtures 660 656
------- -------
11,133 12,300
Accumulated depreciation 6,733 8,765
------- -------
Net property and equipment 4,400 3,535
Intangible assets:
Patents 14,945 14,945
Goodwill 6,698 6,698
Contract rights 11,933 11,933
------- -------
33,576 33,576
Accumulated amortization 14,557 18,266
------- -------
Net intangible assets 19,019 15,310
Other non-current assets 4,812 4,571
------- -------
Total assets $56,589 $38,183
======= =======
</TABLE>
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SOURCE MEDIA, INC.
CONSOLIDATED BALANCE SHEETS (CONTINUED)
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
DECEMBER 31, SEPTEMBER 30,
1998 1999
------------ -------------
<S> <C> <C>
LIABILITIES AND STOCKHOLDERS' EQUITY (CAPITAL DEFICIENCY)
Current liabilities:
Trade accounts payable $ 2,501 $ 826
Accrued interest 2,000 5,000
Accrued payroll 540 1,101
Other accrued liabilities 1,619 4,648
Unearned income 1,750 2,352
--------- ---------
Total current liabilities 8,410 13,927
Long-term debt 100,000 100,000
Minority interests in consolidated subsidiaries 3,840 3,840
Note receivable and accrued interest from minority
stockholder, net of discount of $53 and
$22 in 1998 and 1999, respectively (780) (823)
--------- ---------
3,060 3,017
Senior redeemable payment-in-kind (PIK) preferred stock,
$25 liquidation preference, $.001 par value, net of
discount
Authorized shares - 1,712; Issued and outstanding
shares 914 and 1009 in 1998 and 1999,
respectively 16,628 18,061
Stockholders' equity (capital deficiency):
Common stock, $.001 par value:
Authorized shares - 50,000
Issued shares - 13,021 and 13,914 in 1998
and 1999, respectively 13 14
Less treasury stock, at cost - 280 and 275 in 1998
and 1999, respectively (2,770) (2,716)
Capital in excess of par value 80,269 84,238
Accumulated deficit (148,943) (178,358)
Notes receivable and accrued interest
from stockholders (78) 0
--------- ---------
Total stockholders' equity (capital deficiency) (71,509) (96,822)
--------- ---------
Total liabilities and stockholders' equity (capital deficiency) $ 56,589 $ 38,183
========= =========
</TABLE>
See accompanying notes.
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SOURCE MEDIA, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
QUARTER QUARTER NINE MONTHS NINE MONTHS
ENDED ENDED ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1998 1999 1998 1999
-------------------------------- --------------------------------
<S> <C> <C> <C> <C>
Monetary revenues $ 6,344 $ 4,275 $ 17,335 $ 13,624
Nonmonetary revenues 377 555 1,490 1,437
-------- -------- -------- --------
Total revenues 6,721 4,830 18,825 15,061
Monetary cost of sales 3,480 3,085 8,784 9,826
Nonmonetary cost of sales 377 555 1,490 1,437
-------- -------- -------- --------
Total cost of sales 3,857 3,640 10,274 11,263
-------- -------- -------- --------
Gross profit 2,864 1,190 8,551 3,798
Selling, general and administrative expenses 6,493 4,122 17,827 18,223
Impairment of intangible assets 0 0 25,936 0
Amortization of intangible assets 1,237 1,236 5,084 3,709
Research and development expenses 917 783 2,614 2,302
-------- -------- -------- --------
8,647 6,141 51,461 24,234
-------- -------- -------- --------
Operating loss (5,783) (4,951) (42,910) (20,436)
Interest expense 3,191 3,208 9,601 9,621
Interest income (456) (104) (1,598) (640)
Other (income) expense 13 0 (27) (2)
Net loss ($ 8,531) ($ 8,055) ($50,886) ($29,415)
======== ======== ======== ========
Preferred stock dividends 734 4 2,314 1,433
Net loss attributable to common stockholders (9,265) (8,059) (53,200) (30,848)
======== ======== ======== ========
Basic and diluted net loss per common share ($ 0.76) ($ 0.60) ($ 4.51) ($ 2.32)
======== ======== ======== ========
Weighted average common shares outstanding 12,195 13,499 11,792 13,285
======== ======== ======== ========
</TABLE>
See accompanying notes.
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SOURCE MEDIA, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED SEPTEMBER 30,
1998 1999
-------- --------
<S> <C> <C>
OPERATING ACTIVITIES
Net loss ($50,886) ($29,415)
Adjustments to reconcile net loss to net cash used in
operating activities:
Impairment of intangible assets 25,936 --
Depreciation 1,884 2,032
Amortization of intangible assets 5,084 3,709
Stock based compensation 1,752 894
Non-cash interest expense 602 619
Non-cash interest income (818) (296)
Provision for losses on accounts receivable 251 250
Other, net (46) (43)
Changes in operating assets and liabilities:
Trade accounts receivable (1,786) 1,854
Prepaid expenses and other assets (43) (436)
Deferred expenses 484 (54)
Trade accounts payable and accrued liabilities 2,534 4,915
Unearned income (788) 602
-------- --------
Net cash used in operating activities (15,840) (15,369)
INVESTING ACTIVITIES
Capital expenditures (1,225) (1,166)
Redemption of short-term investments 17,932 6,000
-------- --------
Net cash provided by investing activities 16,707 4,834
FINANCING ACTIVITIES
Proceeds from issuance of common stock upon exercise
of stock options and warrants 722 4,479
Other (160) 162
-------- --------
Net cash provided by financing activities 562 4,641
Net increase (decrease) in cash and cash equivalents 1,429 (5,894)
Cash and cash equivalents at beginning of period 8,431 11,662
-------- --------
Cash and cash equivalents at end of period $ 9,860 $ 5,768
======== ========
</TABLE>
See accompanying notes.
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SOURCE MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Unless the context otherwise requires, all references to the "Company"
or "Source Media" include Source Media, Inc. and its wholly-owned subsidiaries,
IT Network, Inc. ("IT Network"), Interactive Channel, Inc. ("Interactive
Channel"), SMI Holdings, Inc. ("Holdings"), and Interactive Channel Technologies
Inc., marketed under the name of VirtualModem(TM) ("ICT").
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
the Company and its consolidated subsidiaries for the periods indicated.
Operating results for the three months and nine months ended September 30, 1999
are not necessarily indicative of the results that may be expected for the year
ended December 31, 1999. The balance sheet at December 31, 1998 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, 1998.
Since its inception, the Company has financed its operations primarily
with $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 Senior Secured
Notes (the "Notes") and $20.0 million of preferred stock. The interest escrow
account created pursuant to the indenture has been and will be used to fund the
first four interest payments on the Notes. Interest payments from the interest
escrow account were made on May 1, 1998, November 1, 1998 and May 1, 1999. The
Company's primary source of liquidity is its cash, cash equivalents and
restricted investments, which totaled $11.8 million at September 30, 1999. This
cash position consisted of $6.0 million held in escrow for the November 1, 1999
interest payment and $5.8 million of cash available for operations. The
Company's first interest payment of $6.0 million 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 cash needs for working capital and other capital
expenditures related to the Company's business and operations through the fourth
quarter of 1999. Upon the closing of a joint venture with a subsidiary of
Insight Communications Company, Inc., the cost of Interactive TV's operations
will be funded by the joint venture. Additionally, the Company will receive
$12.0 million cash from the sale of common stock related to the Insight
transaction which is expected to adequately fund the Company's continuing
operations for approximately twelve
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months and the interest payment on its debt, due on May 1, 2000. If the Insight
transaction is not approved the Company would be required to seek alternative
financing. There can be no assurance that the Company will be able to obtain
such financing.
2. Computation of Net Loss Per Common Share
Net loss per common share is calculated in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share". Dilutive
earnings per share has not been presented because the options and warrants are
anti-dilutive.
3. Translation of Foreign Currencies
The financial positions and results of operations of ICT and related
Canadian subsidiaries are measured using local currency (Canadian dollar) as the
functional currency. Assets and liabilities of these subsidiaries are translated
at the exchange rate in effect at each balance sheet date. Statement of
operations accounts are translated at the average rate of exchange prevailing
during the period. Translation adjustments and foreign currency gains and losses
have not been significant and accordingly, have not been separately presented.
4. Commitments and Contingencies
Interactive Channel Technologies Inc. and SMI Holdings, Inc. filed a
patent infringement suit against Worldgate Communications, Inc. in federal
district court in Delaware in May 1998. In June 1998, Worldgate filed a
Counterclaim against plaintiffs and Source Media, Inc. for, among other things,
unfair competition, interference with contract, and trade secret
misappropriation. The Counterclaim defendants have denied the allegations in the
Counterclaim and on July 27, 1998 filed a motion to dismiss certain of
Worldgate's claims. The motion was denied by Order of the Court dated May 17,
1999.
The Court held a status conference on May 13, 1999. The following
deadlines for the disposition of the case were set by the Court:
Joinder of Parties and Amendment of Pleadings December 1, 1999
Close of Fact Discovery May 12, 2000
Close of Expert Discovery July 14, 2000
Deadline for Dispositive Motions July 21, 2000
Trial November 27, 2000
Pursuant to the Scheduling Order, limited discovery commenced on August
16, 1999. Full-scale discovery commenced on October 1, 1999. Both parties have
propounded discovery requests, responses to which are due on or before December
1, 1999.
On July 17, 1998, IT Network, Inc. ("ITN") filed a lawsuit against a
former employee of Brite Voice Systems, Inc. ("Brite"), Michael Shell ("Shell"),
the two companies he founded Interactive Media Services, Inc. ("IMS") and
Interactive Information Services, LLC ("IIS"), and a third company called
Talking Directories, Inc. ("TDI"). The lawsuit was filed in the Western
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District of Michigan and alleged two causes of action, one for the copyright
infringement against all of the defendants arising out of the defendants'
alleged use of ITN's 1997 BDR Audio Guide (the "Catalogue") and the thousands of
narrative scripts that correspond to the subject matter categories contained in
the Catalogue (the "Scripts"), and a second for breach of contract against TDI
arising out of TDI's alleged wrongful termination of its information services
contract with ITN. As of September 30, 1999, the litigation was settled with
respect to all defendants.
A total of fourteen class action complaints were filed against Source
Media, Inc. ("SMI") and certain of its officers and directors in the United
States District Court for the Northern District of Texas asserting violations of
sections 10(b) and 20(a) of the Securities Exchange Act and Rule 10b-5 of the
accompanying regulations. The fourteen complaints were consolidated by Judge
Buchmeyer into the first filed case, Hartsell, et al. v. Source Media, Inc., et
al., Civil Action No. 398-CV-1980-R (filed August 21, 1998), on October 9, 1998.
Plaintiffs filed a motion for the appointment of lead plaintiff and
lead plaintiffs' counsel on October 20, 1998. Plaintiff proposed the appointment
of three law firms to serve as "Co-Lead Counsel," Weiss & Yourman, Abbey, Gardy
& Squitieri, and Milberg Weiss Bershad Hynes & Lerach, LLC. On November 12,
1998, defendants filed a statement of non-opposition to the plaintiffs' motion.
The Court granted plaintiffs' motion on January 5, 1999.
Pursuant to an Order entered by the Court on February 24, 1999,
plaintiffs' time for filing the consolidated amended complaint was extended from
February 24, 1999 to March 3, 1999. Plaintiffs filed their amended complaint on
March 3, 1999. Defendants filed a motion to dismiss on April 19,1999, plaintiffs
filed an opposition to the motion on May 24, 1999, and defendants filed a reply
brief on June 12, 1999. A hearing on the motion to dismiss was held on July 15,
1999. By Order dated July 15, 1999, the Court denied defendants' motion.
On July 26, 1999, defendants filed an Application For Immediate
Appellate Review Under 28 U.S.C. ss. 1292(b) concerning two issues central to
the Court's denial of defendants' motion to dismiss. Plaintiffs filed an
opposition on or about August 13, 1999. By Order dated August 24, 1999, the
Court denied defendants' motion.
On August 16, 1999, plaintiffs filed a complaint against Ernst & Young
LLP, Source Media, Inc.'s outside accountants, alleging violations of the
federal securities laws (the "E&Y Complaint"). The facts and circumstances
underlying the E&Y Complaint are similar to those underlying the amended
complaint. By Order dated August 31, 1999, the Court consolidated the E&Y
Complaint with the amended complaint. Ernst & Young moved to dismiss the E&Y
Complaint on September 21, 1999, plaintiffs filed an opposition to the motion on
October 28, 1999 and defendants' reply brief is due on November 19, 1999.
The Court held a status conference on October 8, 1999. In light of the
E&Y Complaint and the resurrection of the mandatory discovery stay as to Ernst &
Young, the Court continued the trial date in the case until October 2, 2000.
Plaintiffs and defendants have submitted alternative scheduling proposals to the
Court regarding deadlines for discovery and dispositive motions. To date, the
Court has not issued a revised scheduling order.
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On October 27, 1999, plaintiffs filed a Summary Notice of Pendency of
Class Action advising class members of the pendency of the litigation.
Plaintiffs filed a proposed Order Approving Class Notices on November 5, 1999.
The proposed Order has not yet been signed by the Court.
On October 6, 1998, Advanced Interactive, Inc. filed a complaint in
U.S. District Court for the Northern District of Illinois, Eastern Division,
against ICT and the following companies: Matsushita Electric Corporation,
Matsushita Electric Industrial Co., Ltd., Sharp Electronics Corp., Sharp Corp.,
Thomson Consumer Electronics, Toshiba Consumer Products, Inc., Toshiba America,
Inc., Toshiba Corporation, General Instruments Corp., Scientific Atlanta, Inc.,
ATI Technologies, Inc., ADS Technologies Inc., Gateway 2000, Inc., STB Systems,
Inc., Hauppauge Computer Works, Inc., WebTV Networks, Inc. and WorldGate
Communications, Inc. (collectively the "Advanced Interactive Defendants").
Advanced Interactive alleges that ICT infringed two claims of one of its patents
by manufacturing, using and/or selling or offering to sell "Sourceware(TM)
ChannelLink(TM)". The same allegation is made against each Advanced Interactive
Defendant for its particular product or service. The Plaintiff seeks damages,
but makes no claims against the patents of ICT or any other Advanced Interactive
Defendant. ICT, and each of the Defendants, have filed an Answer and have
collectively joined the Motion for Partial Summary Judgment submitted by
Matsushita Electric Corporation of America, Sharp Electronics Corp., Sharp Corp.
and the Toshiba Defendants. On May 12, 1999 the court denied Advanced
Interactive's Motion for Summary Judgement of Infringement. The court has not
yet considered the Advanced Interactive Defendant's collective Motion for
Partial Summary Judgment. The Company believes this case is totally without
merit and intends to vigorously defend itself.
On August 3, 1999, the Company announced that it had filed an action in
the District Court of Dallas County, Texas against TV Guide, Inc. for breach of
a Non-Disclosure Agreement entered into in September 1998. The petition sought
damages of approximately $60 million representing the decline in share value
caused by improper statements made by TV Guide and an injunction precluding TV
Guide from any further violations of the Non-Disclosure Agreement. The parties
entered into a settlement agreement and release effective August 31, 1999
pursuant to which TV Guide affirmed and agreed to honor the terms of the
Non-Disclosure Agreement.
In addition, the Company is aware of certain claims against the Company
that have not developed into litigation, or if they have, are dormant, and in
any case are not expected to have a material adverse affect on the Company.
Further, the Company is party to ordinary routine litigation, none of which is
expected to have a material adverse effect on the Company's results of
operations or its financial condition.
As part of the Company's review of its booking performance against
customer sales guarantees, the Company anticipates a shortfall on several
contracts. In connection with these guarantees, the Company has recorded a $0.2
million expense in the third quarter for a total expense of $1.6 million for the
nine months ended September 30, 1999.
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The Company has employment agreements with two executives. The
agreements provide that the Company will pay a base salary amount and grant
stock options over a set term to the employees. In the event of a termination
without cause, the Company remains obligated to make certain payments as defined
in the agreements. One contract terminates in 2001 and the other in 2002.
In the second quarter, the Company entered into severance agreements
with certain executives that provide for salary continuation for up to six
months and Company payment of health insurance premiums.
5. Long-Term Debt
On October 30, 1997, the Company issued Senior Secured Notes (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 into an
escrow account 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. At September 30, 1999, $6.0
million remains in escrow to pay the interest due November 1, 1999.
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 Company's
Senior PIK Preferred Stock (the "Preferred Stock"), dividends on the Preferred
Stock and corporate overhead. The assets of Source Media consist solely of
investments in its subsidiaries and invested proceeds from the Notes and the
Preferred Stock and related warrants. Financial statements for the Subsidiary
Guarantors and the parent, Source Media, Inc., on an unconsolidated basis, 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 terms 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
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redemption, provided, that, at least $65.0 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 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. As of September 30, 1999, the
dealer quoted value of a Note was $0.38 per dollar resulting in an aggregate
fair market value of approximately $38.0 million.
6. Senior PIK Preferred Stock
On October 30, 1997, the Company issued 800 units (the "Units") for an
aggregate purchase price of $20 million, each Unit consisting of 1,000 shares of
non-voting Preferred Stock with a liquidation preference of $25.00 per share and
558.75 warrants (the "October 1997 Warrants"). Each October 1997 Warrant
entitles the holder 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 assets.
Dividends on the Preferred Stock are payable quarterly on each February
1, May 1, August 1 and November 1, commencing February 1, 1998, at an annual
rate of 13 1/2% of the liquidation preference per share. At the Company's
option, on any dividend payment date occurring on or prior to November 1, 2002,
dividends may be paid 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 certificate of
designation governing the terms of the Preferred Stock 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 113 1/2% of 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.
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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 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 further provided 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 designation, 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.
Additionally, $1.2 million of issuance costs were recorded on the Preferred
Stock. The discount and issuance costs on the Preferred Stock are being accreted
as additional preferred stock dividends using the effective dividend rate method
over a ten-year period, resulting in an effective dividend rate of 19.9%. As of
September 30, 1999 the dealer quoted fair market value of the preferred stock
was $5.00 per share for an aggregate value of $5.0 million.
On February 1, May 1 and August 1, 1999 the quarterly dividends due on
the Preferred Stock were paid through the issuance of additional Preferred Stock
having a liquidation preference of $0.8 million for each dividend payment, with
terms identical to those of the Preferred Stock. The estimated fair market value
of the stock issued in lieu of a cash payment on February 1, May 1 and August 1,
1999 was approximately $0.5 million, $0.6 million and $0.1 million,
respectively, which was recorded as preferred stock dividends.
7. Stock Based Compensation
The Company has granted stock options to employees in excess of shares
reserved for issuance under the stock option plan at the date of grant. The
portion of unauthorized options are treated as a variable compensation plan
through the date an amendment to the stock option plan increasing the number of
shares is approved by shareholders. The Company recognizes stock compensation
expense over the vesting period of the related options. Total non-cash stock
based compensation expense for the three month period ended September 30, 1998
was $1.1 million, with income of $0.3 million for the three month period ended
September 30, 1999 due to a decline in the stock price. Total expense amounted
to $1.8 million and $0.9 million, respectively for the nine month periods ended
September 30, 1998 and 1999.
8. Segment Reporting
The Company adopted Statement of Financial Accounting Standards No.
131, "Disclosures about Segments of an Enterprise and Related Information"
("SFAS 131") in the year ended December 31, 1998.
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<PAGE> 14
In accordance with SFAS 131, the Company has identified two reportable
operating segments, IT Network and Interactive TV, for disclosure purposes.
These two segments are regularly reviewed by the Company's management for
determination of the allocation of resources to these businesses.
IT Network sells advertising and related support services to clients
who sponsor a promotional message with interactive content supplied primarily by
IT Network.
Interactive TV has designed and is developing proprietary software and
interactive programming services that can enable digital, two-way television
systems equipped with digital (or advanced analog) set-top boxes to deliver
two-way, interactive programming with the touch of a set-top remote or the use
of a wireless keyboard.
The total revenues, expenses and assets by reportable operating
segments are used in the Company's operations and do not include general
corporate overhead and assets not allocated to the operating units. These assets
and expenses have been separately disclosed for reconciliation purposes.
<TABLE>
<CAPTION>
Three Months Ended September 30, Nine Months Ended September 30,
1998 1999 1998 1999
--------- ---------- --------- ---------
(In Thousands) (In Thousands)
<S> <C> <C> <C> <C>
Monetary revenues:
IT Network $ 6,243 $ 4,275 $ 17,148 $ 13,582
Interactive TV 100 - 187 42
--------- ---------- --------- ---------
Total monetary revenues $ 6,343 $ 4,275 $ 17,335 $ 13,624
========= ========== ========= =========
Nonmonetary revenues:
IT Network $ 377 $ 555 $ 1,490 $ 1,437
Interactive TV - - - -
--------- ---------- --------- ---------
Total nonmonetary revenues $ 377 $ 555 $ 1,490 $ 1,437
========= ========== ========= =========
Net revenues:
IT Network $ 6,620 $ 4,830 $ 18,638 $ 15,019
Interactive TV 100 - 187 42
--------- ---------- --------- ---------
Total net revenues $ 6,720 $ 4,830 $ 18,825 $ 15,061
========= ========== ========= =========
Operating loss:
IT Network $ (614) $ (1,617) $(28,779) $ (5,372)
Interactive TV (2,759) (2,598) (8,733) (8,053)
Corporate $ (2,407) (930) (5,398) (7,011)
--------- ---------- --------- ---------
Total operating loss $ (5,780) $ (5,145) $ (42,910) $ (20,436)
========= ========== ========= =========
</TABLE>
14
<PAGE> 15
<TABLE>
<CAPTION>
December 31, 1998 September 30, 1999
----------------- -------------------
<S> <C> <C>
Identifiable assets:
IT Network $19,408 $16,784
Interactive TV 8,401 6,868
Corporate 28,780 14,531
------- -------
Total identifiable assets $56,589 $38,183
======= =======
</TABLE>
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. Throughout the second quarter of
1998, a significant portion of the customer contracts purchased in the Brite
acquisition were cancelled or not renewed. As a result, the Company reviewed the
value assigned to the contract rights and certain related intangible assets
acquired in the Brite purchase and found them, along with the goodwill
associated with the Brite acquisition, to be impaired, resulting in a write-off
of $25.9 million in the second quarter of 1998.
9. Subsequent Events
On October 25, 1999, the Company announced the successful completion
of its consent solicitation relating to certain provisions of the indenture
governing its $100 million aggregate principal amount of 12% Senior Secured
Notes due 2004 and certain provisions of the certificate of designation
governing its $20 million aggregate original liquidation preference of 13 1/2
Senior PIK Preferred Stock due 2007.
The purpose of the consent solicitation is to permit Source Media to
enter into its proposed joint venture with a subsidiary of Insight
Communications Company, Inc. to conduct Source Media's VirtualModem(TM) and
Interactive Channel businesses. The consummation of the joint venture is also
subject to approval of Source Media's common stockholders at a meeting which is
scheduled to take place on November 17, 1999. The changes relating to the bonds
and preferred stock will become effective upon consummation of the joint
venture, which is expected to occur shortly after approval by the common
stockholders and required regulatory approval, if any. At the same time
as the formation of the joint venture, Source Media would receive a capital
infusion of $12 million, of which Source Media has agreed to place in escrow an
amount sufficient to make the $6 million interest payment on the bonds due May
1, 2000.
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<PAGE> 16
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 Media" include Source Media, Inc. and its wholly-owned subsidiaries,
IT Network, Inc. ("IT Network"), Interactive Channel, Inc. ("Interactive
Channel"), SMI Holdings, Inc. ("Holdings"), and Interactive Channel Technologies
Inc., marketed under the name of VirtualModem(TM) ("ICT").
FORWARD LOOKING INFORMATION AND RISK FACTORS
The Company or its representatives from time to time may make, or may
have made, certain forward-looking statements, whether orally or in writing,
including without limitation any such statements made, or to be made, in the
Management's Discussion and Analysis of Financial Condition and Results of
Operations, press releases and other information contained in its various
filings with the Securities and Exchange Commission. The Company wishes to
ensure that such statements are accompanied by meaningful cautionary statements,
so as to ensure to the fullest extent possible the protections of the "safe
harbor" established in the Private Securities Litigation Reform Act of 1995.
Accordingly, such statements are qualified in their entirety by reference to,
and are accompanied by, the following discussion of certain important factors
that could cause actual results to differ materially from those projected in
such forward-looking statements.
The Company cautions you that this list of factors does not describe
all of the risks of an investment in its common stock. The Company operates in a
rapidly changing business environment, and new risk factors continually emerge.
The Company cannot predict every risk factor, nor can they assess the impact of
all these risk factors on the Company's business or the extent to which any
factor, or combination of factors, may cause actual results to differ from those
projected in any forward-looking statements. Accordingly, you should not rely
upon forward-looking statements as a prediction of the Company's actual results.
Among the factors that could cause actual results to differ materially
from the Company's expectations are the Company's high degree of leverage and
its ability to service debt, the need for additional financing, the Company may
not have sufficient collateral to repay its indebtedness in full, the potential
for a change of control that would require the Company to purchase its notes and
preferred stock, historical and projected losses, risks related to the proposed
transaction with Insight, access to channels on cable television systems and
uncertainty of subscriber acceptance, the uncertainty of a market for
interactive television, the availability of programming, our reliance on
proprietary technology, the further technical development needed to improve the
economics of deploying interactive television to multiple cable systems, a delay
in digital roll-out, the integration of technology with digital set-top boxes,
competition within the industry, uncertainty of customer acceptance of
interactive advertising, the evolving nature of business, anti-takeover effects
of a shareholder rights plan, stock volatility, the market price of the
Company's common stock, the Company's ability to resolve Year 2000 issues in a
timely manner, reliance on key personnel, 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.
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<PAGE> 17
GENERAL
Source Media, Inc. operates through its subsidiaries Holdings, IT
Network, Interactive Channel and ICT in two business segments: IT Network and
Interactive TV.
IT Network sells advertising and related support services to clients
who sponsor a promotional message with interactive content supplied or otherwise
managed by IT Network. IT Network's products and services are distributed
primarily through the Company's publisher partners which include Yellow Page
directories and daily newspapers. IT Network's products and services are
available in North America, Hawaii and the Caribbean. Products and services are
also promoted and distributed over radio, television and the Internet.
The Company's Interactive TV business consists of the combined efforts
of the Interactive Channel and ICT subsidiaries. The Company has designed,
fielded and continues to develop proprietary software and interactive
programming services that can enable digital, two-way television systems
equipped with digital (or advanced analog) set-top boxes to deliver two-way,
interactive programming with the touch of a set-top remote or the use of a
wireless keyboard.
On July 29, 1999 the Company announced that it had signed definitive
agreements to form a joint venture with a subsidiary of Insight Communications
Company, Inc. See further discussion of this transaction in Part II - OTHER
INFORMATION, Item 5 - Other Information.
NINE MONTHS ENDED SEPTEMBER 30, 1999 AND 1998
Monetary revenues decreased 21% to $13.6 million for the nine months
ended September 30, 1999 from $17.3 million for the same period in 1998. This
decrease is primarily due to decreases of $2.1 million in system management and
information services and $1.4 million in advertising sales. In addition, the
1998 period included $0.2 million of revenues associated with an Interactive
Channel test market. There have been no such revenues in 1999. The decrease in
system management and information services is attributable to increased industry
competition, customers migrating to their own systems and Year 2000 hardware
issues at customers. Advertising sales decreased primarily due to a
reorganization of the sales department and delays in implementing new products
in 1999.
Monetary cost of sales increased 12% to $9.8 million for the nine
months ended September 30, 1999 from $8.8 million for the same period 1998
primarily as a result of $1.6 million of expense recognized for anticipated
payments to customers for unmet sales guarantees and $0.3 million of cost
related to new products in 1999, partially offset by savings of $0.5 million in
page costs related to decreased advertising sales and other operational savings
of $0.4 million.
Nonmonetary revenues and nonmonetary cost of sales decreased 4% to $1.4
million for the nine months ended September 30, 1999. Nonmonetary sales
accounted for 10% of revenues
17
<PAGE> 18
for the nine months ended September 30, 1999 and 8% of the revenues for the nine
months ended September 30, 1998.
SG&A expenses increased 2% for the nine months ended September 30, 1999
to $18.2 million from $17.8 million for the same period in 1998. Increased
expenses were incurred for: (i) $1.8 million in legal and professional costs
incurred in connection with the proposed Prevue joint venture that were expensed
after the termination of the proposed Prevue transaction; (ii) $0.6 million of
legal expense attributable to other litigation (described in Note 4 in the Notes
to Consolidated Financial Statements); (iii) $0.6 million of accrued severance
to certain employees. These increases were offset by decreases of $0.9 million
for non-cash variable compensation expense for certain stock options granted to
certain employees in excess of share authorized, the elimination of $0.7 million
of transitional cost related to the integration of acquired businesses incurred
in 1998, decreased trade advertising expense of $0.3 million in 1999 and other
SG&A savings of $0.7 million.
Impairment of intangible assets included in the prior year amount
relates to $25.9 million of write-offs of certain intangible assets described in
the Company's Form 10-K.
Amortization of intangible assets decreased 27% to $3.7 million for the
nine months ended September 30, 1999 from $5.1 million for the same period in
1998 due to a lower intangible asset balance.
Research and development expenses decreased 12% to $2.3 million for the
nine months ended September 30, 1999 from $2.6 million for the same period in
1998 as a result of reduced development requirements of launched products.
Interest expense remained unchanged at $9.6 million for the nine months
ended September 30, 1999 and 1998. This expense is associated with a $100
million debt financing completed by the Company in October 1997 and described in
detail in the Notes to Consolidated Financial Statements.
Interest income decreased 63% to $0.6 million for the nine months ended
September 30, 1999 from $1.6 million for the same period in 1998 due to lower
investment and cash balances as a result of debt interest payments and normal
operating expenditures.
Preferred Stock dividends of $1.4 million and $2.3 million for the nine
months ended September 30, 1999 and 1998, respectively, relate to the $20
million Preferred Stock financing completed by the Company in October 1997 and
described in detail in the Notes to Consolidated Financial Statements. Dividends
are recorded at the fair market value of the shares issued resulting in a lower
dividend expense recognized in the current year.
THREE MONTHS ENDED SEPTEMBER 30, 1999 AND 1998
Monetary revenues decreased 33% to $4.3 million for the three months
ended September 30, l999 from $6.3 million for the same period in 1998. This
decrease is primarily due to
18
<PAGE> 19
decreases of $1.3 million in advertising sales and $0.7 million in information
services and system management. The decrease in system management and
information services is attributable to increased industry competition,
customers migrating to their own systems and Year 2000 hardware issues at
customers. Advertising sales decreased primarily due to a reorganization of the
sales department and delays in implementing new products.
Monetary cost of sales decreased 11% to $3.1 million for the three
months ended September 30, 1999 from $3.5 million for the same period in 1998 as
a result of a $0.3 million reduction in page costs related to the decreased
advertising sales, $0.3 million of operating efficiencies offset by $0.2 million
of expense recognized for anticipated payments to customers for unmet sales
guarantees on various advertising contracts.
Nonmonetary revenues and nonmonetary cost of sales increased 47% to
$0.6 million for the three months ended September 30, 1999. Nonmonetary sales
accounted for 11% of revenues for the three months ended September 30, 1999
compared to 6% of revenues for the same period in 1998.
SG&A expenses decreased 37% to $4.1 million for the three months ended
September 30, 1999 from $6.5 million for the same period in 1998. The decrease
is primarily due to a $1.4 million decrease in non-cash variable compensation
expense, $0.4 million of savings in compensation related expenses and $0.6
million in cost reductions in other administrative expenses.
Amortization of intangible assets remained unchanged at $1.2 million
for the three months ended September 30, 1999.
Research and development expenses decreased 15% to $0.8 million for the
three months ended September 30, 1999 from $0.9 million for the three months
ended September 30, 1998, primarily due to reduced development requirements of
launched products.
Interest expense remained unchanged at $3.2 million for the three
months ended September 30, 1999 and 1998. This expense is associated with a $100
million debt financing completed by the Company in October 1997 and described in
detail in the Notes to Consolidated Financial Statements.
Interest income decreased 77% to $0.1 million for the three months
ended September 30, 1999 from $0.5 million for the same period in 1998 due to
lower investment and cash balances as a result of debt interest payments and
normal operating expenditures.
Preferred Stock dividends of zero and $0.7 million for the three months
ended September 30, 1999 and 1998, respectively, relate to the $20 million
Preferred Stock financing completed by the Company in October 1997 and described
in detail in the Notes to Consolidated Financial Statements. Dividends are
recorded at the fair market value of the shares issued resulting in a lower
dividend expense recognized in the current year.
19
<PAGE> 20
LIQUIDITY AND CAPITAL RESOURCE
Since its inception, the Company has experienced substantial operating
losses and net losses as a result of its efforts to develop, deploy and support
IT Network and develop, conduct trials and commercially launch Interactive TV.
As of September 30, 1999, the Company had an accumulated deficit of $178.4
million and had used cumulative net cash in operations of $89.1 million. The
difference at September 30, 1999, between the accumulated deficit and cumulative
net cash used in operations since inception was attributable primarily to
charges related to financing incentives and extinguishment of debt, variable
compensation expense, write-downs of analog set-top boxes and intangible assets,
depreciation and amortization and other non-cash expenses. 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 1999, although it expects
that cash generated in IT Network operations excluding related interest expense
will be sufficient to meet IT Network's operating requirements through 1999. Any
launch of the Company's television products and services may require additional
expenditures, which may require the Company to raise additional capital.
The definitive agreements between the Company and Insight, provide,
among others, the following benefits to the Company: (i) at closing, the
Interactive TV research and development costs and certain other costs would
become costs of the joint venture; (ii) at closing, Insight would pay the
Company $12.0 million cash for 842,105 shares of common stock, and (iii) at
closing, Insight would receive warrants which Insight could exercise at any time
within five years to buy approximately 4.6 million shares of the Company's
common stock at $20.00 per share, which if fully exercised, would result in
proceeds of approximately $92.0 million and give Insight an approximate 20%
ownership of the Company. Requirements for closing the Insight transaction
include shareholder, bondholder and potential regulatory approval. Bondholder
and preferred stockholder approval has been obtained as of October 25, 1999. The
meeting to obtain common stockholder approval is scheduled for November 17,
1999.
Since its inception, the Company has financed its operations primarily
with $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 Senior Secured
Notes (the "Notes") and $20.0 million of preferred stock. The interest escrow
account created pursuant to the indenture has been and will be used to fund the
first four interest payments on the Notes. Interest payments from the interest
escrow account were made on May 1, 1998, November 1, 1998 and May 1, 1999. The
Company's primary source of liquidity is its cash, cash equivalents and
restricted investments, which totaled $11.8 million at September 30, 1999. This
cash position consisted of $6.0 million held in escrow for the November 1, 1999
interest payment and $5.8 million of cash available for operations. The
Company's first interest 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 cash needs for working capital and other capital
expenditures related to the Company's business and operations through the fourth
quarter of 1999. Upon the closing of the
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<PAGE> 21
Insight transaction, the cost of Interactive TV's operations will be funded by
the joint venture. Additionally, the Company will receive $12.0 million cash
from the sale of common stock related to the Insight transaction which is
expected to adequately fund the Company's continuing operations for
approximately twelve months and the interest payment on its debt, due on May 1,
2000. If the Insight transaction is not approved the Company would be required
to seek alternative financing. There can be no assurance that the Company will
be able to obtain such financing.
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, along with customer
acceptance of Internet advertising; (ii) the success and timing of the
development, introduction and deployment of Interactive TV; (iii) the extent to
which the Company is able to generate revenues from Interactive TV; (iv) the
number of file servers and other equipment which the Company purchases in
support of Interactive TV; (v) the levels of advertising expenditures necessary
to increase awareness of Interactive TV; (vi) the extent of market acceptance of
the Company's products; (vii) potential acquisitions or asset purchases; (viii)
the deployment of digital set-top boxes incorporating the Company's technology;
(ix) the capital required to address the Company's Year 2000 issue; (x) the
proposed transaction with Insight and (xi) competitive factors.
YEAR 2000 DISCLOSURES
The Year 2000 issue is the result of computer programs being written
using two digits rather than four to define the applicable year. Any of the
Company's computer programs or hardware that have date-sensitive software or
embedded chips may recognize a date using "00" as the year 1900 rather than the
year 2000. This could result in a system failure or miscalculations causing
disruptions of operations, including, among other things, a temporary inability
to process transactions, send invoices, or engage in similar normal business
activities.
Based on recent assessments, the Company determined that it will be
required to modify or replace portions of its software and certain hardware so
that those systems will properly utilize dates beyond December 31, 1999. The
Company presently believes that with modifications or replacements of existing
software and certain hardware, the Year 2000 issue can be mitigated. However, if
such modifications and replacements are not made, or are not completed in a
timely manner, the Year 2000 issue could have a material impact on the
operations of the Company.
The Company's plan to resolve the Year 2000 issue involves the
following four phases: assessment, remediation, testing and implementation. To
date, the Company has completed its assessment of all systems that could be
significantly affected by the Year 2000. The Company's three operating
subsidiaries, ICT, Interactive Channel and IT Network, as well as the corporate
unit were included in the assessment. The assessment indicated that most of the
Company's significant information technology systems could be affected. That
assessment also indicated that software and hardware (embedded chips) used in
the IT Network's interactive voice response systems also are at risk
(hereinafter referred to as operating systems). In addition, the Company
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<PAGE> 22
is gathering information about the Year 2000 compliance status of its
significant suppliers and subcontractors and is continuing to monitor their
compliance.
Regarding its information technology, the Company is approximately 99%
complete on the remediation phase and expects to complete software reprogramming
and replacement for all systems no later than November 30, 1999. Once software
is reprogrammed or replaced for a system, the Company will begin testing and
implementation. These phases run concurrently for different systems. To date,
the Company has completed all of its testing and has implemented approximately
99% of its remediated systems. Completion of the testing phase for all
significant systems has occurred and all remediated systems are expected to be
fully tested and implemented by November 30, 1999.
The Company has initiated the remediation phase of its operating
equipment. The remediation of operating equipment is significantly more
difficult than the remediation of the information technology systems because
some of the software operating systems are no longer supported by the
manufacturers of that equipment. Testing of this equipment is also more
difficult than the testing of the information technology systems; the Company is
approximately 95% complete with the testing of its remediated operating
equipment. Once testing is complete, the operating equipment will be ready for
immediate use. The Company expects to complete its remediation of operating
equipment by November 30, 1999. Testing and implementation of affected equipment
is expected to be completed by November 30, 1999.
The Company is in the process of working with third party vendors to
ensure that the Company's systems that interface directly with third parties are
Year 2000 compliant by December 31, 1999. The Company has completed 100% of its
remediation efforts on these systems and is 100% complete with the testing
phase. Implementation has been completed.
The Company is querying its significant suppliers and subcontractors
that do not share information systems with the Company (external agents). To
date, the Company is not aware of any external agent with a Year 2000 issue that
would materially impact the Company's results of operations, liquidity, or
capital resources. However, the Company has no means of ensuring that external
agents will be Year 2000 ready. The inability of external agents to complete
their Year 2000 resolution process in a timely manner could materially impact
the Company. The effect of non-compliance by external agents is not
determinable.
Additionally, the Company is exposed to the risk that customers may
elect to discontinue receiving telephone information services due to the
customer's equipment not being upgraded to address Year 2000 problems, although
various hardware and software solutions exist. Certain customers have
discontinued service which has resulted in a loss of revenues to the Company.
Further losses of revenue may occur.
The Company will utilize both internal and external resources to
reprogram, or replace, test, and implement the software and operating equipment
for Year 2000 modifications. The total cost of the Year 2000 project is
estimated at $1.0 million and is being funded through operating cash flows. To
date, the Company has incurred expenses of approximately $0.7 million, related
to all phases of the Year 2000 project. Of the total remaining project costs,
approximately $0.2
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<PAGE> 23
million is attributable to the purchase of new software and operating equipment,
which will be capitalized. The remaining $0.1 million relates to repair of
hardware and software that will be expensed as incurred.
Management of the Company believes it has an effective program in place
to resolve the Year 2000 issue in a timely manner. The Company has not yet
completed all necessary phases of the Year 2000 program. There can be no
assurance that the Company's efforts to solve its potential Year 2000 problems
will be successful, or even partially successful. In the event that the Company
does not complete any additional phases, the Company may be unable to take
customer orders, provide services and products, invoice customers or collect
payments. In addition, disruptions in the economy generally resulting from Year
2000 issues could also materially adversely affect the Company. The Company
could be subject to litigation for computer systems product failure, equipment
shutdown or failure to properly date business records. The amount of potential
liability and lost revenue cannot be reasonably estimated at this time.
The Company has contingency plans for certain critical applications and
is working on such plans for others. These contingency plans involve manual
workarounds, telecommunication alternatives, staff adjustments and other
appropriate actions.
NET OPERATING LOSS CARRYFORWARDS
At December 31, 1998, Holdings had net operating loss carryforwards of
approximately $87.4 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 a portion of
the net operating losses is limited to approximately $9.0 million in a given
year.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Company is exposed to changes in interest rates related primarily
to its Notes and Preferred Stock arrangements. Under its current policies, the
Company does not use interest rate derivative instruments to manage exposure to
interest rate changes. At September 30, 1999, the Company had Notes outstanding
of $100.0 million, due November 1, 2004, which bear interest at a fixed rate of
12% and Preferred Stock outstanding of $24.4 million due November 1, 2007, which
bears interest at a fixed rate of 13 1/2%. The fair value of the Notes and
Preferred Stock at September 30, 1999 was approximately $38.0 million and $5.0
million, respectively, based upon dealer quoted market prices.
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<PAGE> 24
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings
Interactive Channel Technologies Inc. and SMI Holdings, Inc. filed a
patent infringement suit against Worldgate Communications, Inc. in federal
district court in Delaware in May 1998. In June 1998, Worldgate filed a
Counterclaim against plaintiffs and Source Media, Inc. for, among other things,
unfair competition, interference with contract, and trade secret
misappropriation. The Counterclaim defendants have denied the allegations in the
Counterclaim and on July 27, 1998 filed a motion to dismiss certain of
Worldgate's claims. The motion was denied by Order of the Court dated May 17,
1999.
The Court held a status conference on May 13, 1999. The following
deadlines for the disposition of the case were set by the Court:
Joinder of Parties and Amendment of Pleadings December 1, 1999
Close of Fact Discovery May 12, 2000
Close of Expert Discovery July 14, 2000
Deadline for Dispositive Motions July 21, 2000
Trial November 27, 2000
Pursuant to the Scheduling Order, limited discovery commenced on August
16, 1999. Full-scale discovery commenced on October 1, 1999. Both parties have
propounded discovery requests, responses to which are due on or before December
1, 1999.
On July 17, 1998, IT Network, Inc. ("ITN") filed a lawsuit against a
former employee of Brite Voice Systems, Inc. ("Brite"), Michael Shell ("Shell"),
the two companies he founded Interactive Media Services, Inc. ("IMS") and
Interactive Information Services, LLC ("IIS"), and a third company called
Talking Directories, Inc. ("TDI"). The lawsuit was filed in the Western District
of Michigan and alleged two causes of action, one for the copyright infringement
against all of the defendants arising out of the defendants' alleged use of
ITN's 1997 BDR Audio Guide (the "Catalogue") and the thousands of narrative
scripts that correspond to the subject matter categories contained in the
Catalogue (the "Scripts"), and a second for breach of contract against TDI
arising out of TDI's alleged wrongful termination of its information services
contract with ITN. As of September 30, 1999, the litigation was settled with
respect to all defendants.
A total of fourteen class action complaints were filed against Source
Media, Inc. ("SMI") and certain of its officers and directors in the United
States District Court for the Northern District of Texas asserting violations of
sections 10(b) and 20(a) of the Securities Exchange Act and Rule 10b-5 of the
accompanying regulations. The fourteen complaints were consolidated by Judge
Buchmeyer into the first filed case, Hartsell, et al. v. Source Media, Inc., et
al., Civil Action No. 398-CV-1980-R (filed August 21, 1998), on October 9, 1998.
Plaintiffs filed a motion for the appointment of lead plaintiff and
lead plaintiffs' counsel on October 20, 1998. Plaintiff proposed the appointment
of three law firms to serve as "Co-Lead Counsel," Weiss & Yourman, Abbey, Gardy
& Squitieri, and Milberg Weiss Bershad Hynes & Lerach, LLC. On November 12,
1998, defendants filed a statement of non-opposition to the plaintiffs' motion.
The Court granted plaintiffs' motion on January 5, 1999.
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<PAGE> 25
Pursuant to an Order entered by the Court on February 24, 1999,
plaintiffs' time for filing the consolidated amended complaint was extended from
February 24, 1999 to March 3, 1999. Plaintiffs filed their amended complaint on
March 3, 1999. Defendants filed a motion to dismiss on April 19, 1999,
plaintiffs filed an opposition to the motion on May 24, 1999, and defendants
filed a reply brief on June 12, 1999. A hearing on the motion to dismiss was
held on July 15, 1999. By Order dated July 15, 1999, the Court denied
defendants' motion.
On July 26, 1999, defendants filed an Application For Immediate
Appellate Review Under 28 U.S.C. Section 1292(b) concerning two issues central
to the Court's denial of defendants' motion to dismiss. Plaintiffs filed an
opposition on or about August 13, 1999. By Order dated August 24, 1999, the
Court denied defendants' motion.
On August 16, 1999, plaintiffs filed a complaint against Ernst & Young
LLP, Source Media, Inc.'s outside accountants, alleging violations of the
federal securities laws (the "E&Y Complaint"). The facts and circumstances
underlying the E&Y Complaint are similar to those underlying the amended
complaint. By Order dated August 31, 1999, the Court consolidated the E&Y
Complaint with the amended complaint. Ernst & Young moved to dismiss the E&Y
Complaint on September 21, 1999, plaintiffs filed an opposition to the motion on
October 28, 1999 and defendants' reply brief is due on November 19, 1999.
The Court held a status conference on October 8, 1999. In light of the
E&Y Complaint and the resurrection of the mandatory discovery stay as to Ernst &
Young, the Court continued the trial date in the case until October 2, 2000.
Plaintiffs and defendants have submitted alternative scheduling proposals to the
Court regarding deadlines for discovery and dispositive motions. To date, the
Court has not issued a revised scheduling order.
On October 27, 1999, plaintiffs filed a Summary Notice of Pendency of
Class Action advising class members of the pendency of the litigation.
Plaintiffs filed a proposed Order Approving Class Notices on November 5, 1999.
The proposed Order has not yet been signed by the Court.
On October 6, 1998, Advanced Interactive, Inc. filed a complaint in
U.S. District Court for the Northern District of Illinois, Eastern Division,
against ICT and the following companies: Matsushita Electric Corporation,
Matsushita Electric Industrial Co., Ltd., Sharp Electronics Corp., Sharp Corp.,
Thomson Consumer Electronics, Toshiba Consumer Products, Inc., Toshiba America,
Inc., Toshiba Corporation, General Instruments Corp., Scientific Atlanta, Inc.,
ATI Technologies, Inc., ADS Technologies Inc., Gateway 2000, Inc., STB Systems,
Inc., Hauppauge Computer Works, Inc., WebTV Networks, Inc. and WorldGate
Communications, Inc. (collectively the "Advanced Interactive Defendants").
Advanced Interactive alleges that ICT infringed two claims of one of its patents
by manufacturing, using and/or selling or offering to sell "Sourceware(TM) and
ChannelLink(TM)". The same allegation is made against each Advanced Interactive
Defendant for its particular product or service. The Plaintiff seeks damages,
but makes no claims against the patents of ICT or any other Advanced Interactive
Defendant. ICT, and each of the Defendants, have filed an Answer and have
collectively joined the Motion for Partial Summary Judgment submitted by
Matsushita Electric Corporation of America, Sharp
25
<PAGE> 26
Electronics Corp., Sharp Corp. and the Toshiba Defendants. On May 12, 1999 the
court denied Advanced Interactive's Motion for Summary Judgement of
Infringement. The court has not yet considered the Advanced Interactive
Defendant's collective Motion for Partial Summary Judgment. The Company believes
this case is totally without merit and intends to vigorously defend itself.
On August 3, 1999, the Company announced that it had filed an action in
the District Court of Dallas County, Texas against TV Guide, Inc. for breach of
a Non-Disclosure Agreement entered into in September 1998. The petition sought
damages of approximately $60 million representing the decline in share value
caused by improper statements made by TV Guide and an injunction precluding TV
Guide from any further violations of the Non-Disclosure Agreement. The parties
entered into a settlement agreement and release on August 31, 1999 pursuant to
which TV Guide affirmed and agreed to honor the terms of the Non-Disclosure
Agreement.
In addition, the Company is aware of certain claims against the
Company that have not developed into litigation, or if they have, are dormant,
and in any case are not expected to have a material adverse affect on the
Company. Further, the Company is party to ordinary routine litigation, none of
which is expected to have a material adverse effect on the Company's results of
operations or its financial condition.
Item 2 - Changes in Securities and Use of Proceeds - 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
As part of the Company's review of its booking performance against
customer sales guarantees, the Company anticipates a shortfall on several
contracts. In connection with these guarantees, the Company has recorded a $0.2
million expense in the third quarter for total expense of $1.6 million for the
nine months ended September 30, 1999.
The Company has employment agreements with two executives. The
agreements provide that the Company will pay a base salary amount and grant
stock options over a set term to the employees. In the event of a termination
without cause, the Company remains obligated to make certain payments as defined
in the agreements. One contract terminates in 2001 and the other in 2002.
On July 29, 1999, Source Media, Inc. and a wholly-owned subsidiary of
Insight Communications Company, Inc. ("Insight") entered into definitive
agreements to form a joint venture ("Newco") to conduct all the lines of
business currently conducted by the Company relating to its "VirtualModem" and
"Interactive Channel" products and businesses (the "Transferred Businesses").
The completion of the transaction is subject to the parties' fulfillment of
certain closing conditions.
26
<PAGE> 27
Pursuant to the terms of a Common Stock and Warrants Purchase Agreement
(the "Purchase Agreement"), upon the formation of Newco, Insight will acquire
842,105 shares of common stock of the Company, representing approximately 6% of
the issued and outstanding stock of the Company, for a purchase price of $12
million in cash ($14.25 per share). The Company will also issue to Insight
five-year warrants to acquire up to an additional 4,596,786 shares of the
Company's common stock at an exercise price of $20.00 per share, representing,
together with the above-mentioned 842,105 shares of common stock, approximately
20% of the Company's fully diluted equity. The Purchase Agreement contains
provisions to protect Insight's interest in the Company, including preemptive
rights and board representation. Initially, upon the closing of the transaction,
the Company's board of directors would consist of seven members, three of whom
would be designated by Insight.
Under the terms of a Contribution Agreement (the "Contribution
Agreement"), Newco would be capitalized initially with a $13 million equity
infusion by Insight and with the Company's asset contribution described below.
Both Insight and the Company will receive a 50% equity ownership in Newco in
consideration for their contribution. The Company will assign all its right,
title and interest in and to the intellectual property that has application in
the VirtualModem and Interactive Channel businesses to Newco, to the extent
assignable, and will grant to Newco an exclusive, perpetual, royalty free,
irrevocable, worldwide license (the "Newco License"), with the right to
sublicense, to all of the intellectual property not freely assignable by the
Company, to the extent such intellectual property permits the grant of licenses,
except that in each case the intellectual property covered by such assignment
and license will specifically exclude any television programming content that is
developed in the future by the Company or any of its subsidiaries. Newco will
grant back to the Company a non-exclusive, perpetual, royalty free, irrevocable
worldwide license of the intellectual property used in the Company's businesses
other than the Transferred Businesses. In addition, the Company will transfer to
Newco all the equipment, intangible property and data, contract rights,
inventory and accounts receivable which have use in the Transferred Businesses
excluding any routine, general or non-unique assets.
The Company will serve as the manager of Newco and will manage the
day-to-day operations of Newco. However, certain special actions by Newco would
require approval of a four-member management committee. The Company and Insight
would have equal representation on the management committee. Such special
actions would include material deviations from Newco's business plan and budget,
issuance of additional equity, distributions to equity holders, asset sales and
other significant matters. The management agreement to be entered into between
the Company and Insight on the closing date will set forth the terms under which
the business of Newco will be conducted. Unless agreed to otherwise, the Company
will continue to provide all necessary services and business functions for Newco
and will be reimbursed for the related costs and expenses without any mark-up.
The management agreement will also contain provisions granting Newco
the sole and exclusive ownership of any inventions, improvements or
modifications, including any related intellectual property rights, which are
developed by employees, officers or other parties associated with the Company in
the performance of the management agreement.
27
<PAGE> 28
The operating agreement to be entered into on closing by the Company
and Insight contemplates a "buy-sell" arrangement whereby either party,
following the fifth anniversary of the joint venture, may send to the other
party a notice specifying the value that the notifying party assigns to 100% of
the equity ownership of Newco. The notified party is then required to either
purchase the entire equity ownership from the notifying party or sell its entire
equity ownership to the notifying party, in each case using the valuation set
forth in the notice. The operating agreement provides for certain transfer
restrictions relating to Newco interests, drag-along and tag-along rights with
respect to such interests and rights upon a change in control of the Company.
The definitive agreements contemplate an affiliation agreement between
Newco and Insight relating to the carriage of the Interactive Channel over
Insight's cable television systems, as well as a license agreement granting
Insight an irrevocable license to use Newco's intellectual property in
connection with such cable television systems.
Until the date of the closing, the Company is prohibited from
participating in any substantive negotiations with any person or entity, other
than Insight or its affiliates, concerning a business combination, the
disposition of any of its material assets or, with certain exceptions, the
issuance of any of its securities.
All of the obligations of Insight are guaranteed by its parent, Insight
Communications Company, Inc.
Upon the completion of the transaction with Insight substantially on
the terms set forth in this Form 10-Q, the Company's business will be subject to
additional risks, including the dilutive effect of shares and warrants to be
issued to Insight and the ability of Newco to obtain distribution and negotiate
licensing arrangements for the Interactive Channel.
The consummation of the transaction will be subject to the approval of
the transaction from the Company's common stockholders, as well as from the
holders of its long-term debt and preferred stock and, any potentially required
clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976. The
Company obtained approval of the Bondholders and Preferred Stockholders on
October 25, 1999. The Company give no assurances that the remaining conditions
will be met and accordingly, that will consummate a transaction with Insight on
the terms contained in this Form 10-Q, or at all.
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
September 30, 1999.
None.
28
<PAGE> 29
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: November 15, 1999 By: /s/ PAUL TIGH
----------------- ------------------------------------------
Paul Tigh
Chief Financial Officer and Treasurer
(Principal Financial Officer and
Duly Authorized Officer)
29
<PAGE> 30
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION
- ------- -----------
<S> <C>
27 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> SEP-30-1999
<CASH> 5,768
<SECURITIES> 0
<RECEIVABLES> 1,491
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 14,767
<PP&E> 12,300
<DEPRECIATION> 8,765
<TOTAL-ASSETS> 38,183
<CURRENT-LIABILITIES> 13,927
<BONDS> 100,000
18,061
0
<COMMON> 14
<OTHER-SE> (96,836)
<TOTAL-LIABILITY-AND-EQUITY> 38,183
<SALES> 15,061
<TOTAL-REVENUES> 15,061
<CGS> 11,263
<TOTAL-COSTS> 24,234
<OTHER-EXPENSES> (642)
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 9,621
<INCOME-PRETAX> (29,414)
<INCOME-TAX> 0
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (30,848)
<EPS-BASIC> (2.32)
<EPS-DILUTED> (2.32)
</TABLE>
