<PAGE> 1
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, 2000
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 7, 2000: 17,618,712
<PAGE> 2
SOURCE MEDIA, INC.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2000
PART I. FINANCIAL INFORMATION
<TABLE>
<CAPTION>
Page Number
-----------
<S> <C> <C>
Item 1. Consolidated Financial Statements of Source Media, Inc.
Consolidated Balance Sheets of Source Media, Inc. (Unaudited)
December 31, 1999 and September 30, 2000 4-5
Consolidated Statements of Operations of Source Media, Inc. (Unaudited)
Three and nine months ended September 30, 1999 and 2000 6
Consolidated Statements of Cash Flows of Source Media, Inc. (Unaudited) 7
Nine months ended September 30, 1999 and 2000
Consolidated Statements of Stockholder's Equity (Capital Deficiency) 8
of Source Media, Inc. (Unaudited) September 30, 2000
Notes to Consolidated Financial Statements of Source Media,
Inc. (Unaudited) 9-19
Financial Statements of SourceSuite LLC
Balance Sheet of SourceSuite LLC (Unaudited) September 30, 2000 20
Statement of Operations of SourceSuite LLC (Unaudited) Three
months ended September 30, 2000 and Period from Inception
(March 3, 2000) to September 30, 2000 21
Statement of Cash Flows of SourceSuite LLC (Unaudited)
Period from Inception (March 3, 2000) to September 30, 2000 22
Statement of Members' Equity of SourceSuite LLC (Unaudited) 23
September 30, 2000
Notes to Financial Statements of SourceSuite LLC (Unaudited)
Period from Inception (March 3, 2000) to September 30, 2000 24-26
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 27-33
</TABLE>
2
<PAGE> 3
<TABLE>
<CAPTION>
Page Number
-----------
<S> <C> <C>
Item 3. Quantitative and Qualitative Disclosures About Market Risk 34
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 35
Item 2. Changes in Securities and Use of Proceeds 35
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 N/A
Item 6. Exhibits and Reports on Form 8-K 35
</TABLE>
3
<PAGE> 4
SOURCE MEDIA, INC.
CONSOLIDATED BALANCE SHEETS
ASSETS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
DECEMBER 31, SEPTEMBER 30,
1999 2000
------------- -------------
<S> <C> <C>
Current Assets:
Cash and cash equivalents $ 10,910 $ 13,171
Short-term investments 2,500 --
Restricted investments 5,997 339
Trade accounts receivable, less allowance for doubtful
accounts of $605 and $558 in 1999 and 2000, respectively 1,643 1,573
Related party receivables 1,458 473
Prepaid expenses and other current assets 1,068 1,224
Investment in securities available for sale -- 25,639
------------- -------------
Total current assets 23,576 42,419
Property and equipment:
Production equipment 4,511 4,403
Computer equipment 3,612 3,461
Other equipment 1,612 2,626
Furniture and fixtures 656 659
------------- -------------
10,391 11,149
Accumulated depreciation 7,957 9,953
------------- -------------
Net property and equipment 2,434 1,196
Intangible assets:
Goodwill 3,688 3,688
Contract rights 11,933 11,933
------------- -------------
15,621 15,621
Accumulated amortization 6,119 7,871
------------- -------------
Net intangible assets 9,502 7,750
Investment in joint venture 18,669 2,766
Other non-current assets 3,835 2,977
------------- -------------
Total assets $ 58,016 $ 57,108
============= =============
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
4
<PAGE> 5
SOURCE MEDIA, INC.
CONSOLIDATED BALANCE SHEETS
LIABILITIES AND STOCKHOLDERS' EQUITY (CAPITAL DEFICIENCY)
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
DECEMBER 31, SEPTEMBER 30,
1999 2000
------------- -------------
<S> <C> <C>
Current Liabilities:
Trade accounts payable $ 955 $ 567
Accrued interest 1,991 4,566
Accrued payroll 591 558
Other accrued liabilities 3,706 2,791
Unearned income 1,925 1,911
------------- -------------
Total current liabilities 9,168 10,393
Long-term debt 96,250 88,533
Minority interests in consolidated subsidiaries 3,840 3,840
Note receivable and accrued interest from minority stockholder,
net of discount of $12 and $0 in 1999 and 2000, respectively (837) (860)
------------- -------------
3,003 2,980
Senior redeemable payment-in-kind (PIK) preferred
stock, $25 dollar per share liquidation preference, $.001 par value, net of
discount Authorized shares - 1,712; Issued and outstanding
shares 1,043 and 529 in 1999 and 2000, respectively 18,467 8,426
Non-participating preferred stock, $25 dollar per share liquidation
preference, $.001 par value; Authorized and issued - 1 single share -- --
Stockholders' equity (capital deficiency): Common stock, $.001 par value:
Authorized shares - 50,000; 16,278 and 17,869
issued and outstanding in 1999 and 2000, respectively 16 18
Less treasury stock, at cost - 268 and 250 shares in
1999 and 2000, respectively (2,647) (2,476)
Capital in excess of par value 120,883 136,550
Accumulated other comprehensive income -- (61,799)
Accumulated deficit (187,124) (125,517)
------------- -------------
Total stockholders' equity (capital deficiency) (68,872) (53,224)
------------- -------------
Total liabilities and stockholders' equity (capital deficiency) $ 58,016 $ 57,108
============= =============
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
5
<PAGE> 6
SOURCE MEDIA, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS THREE MONTHS NINE MONTHS NINE MONTHS
ENDED ENDED ENDED ENDED
SEPTEMBER 30, 1999 SEPTEMBER 30, 2000 SEPTEMBER 30, 1999 SEPTEMBER 30, 2000
------------------ ------------------ ------------------ ------------------
<S> <C> <C> <C> <C>
Monetary revenues $ 4,275 $ 4,063 $ 13,624 $ 12,626
Nonmonetary revenues 555 397 1,437 1,723
------------------ ------------------ ------------------ ------------------
Total revenues 4,830 4,460 15,061 14,349
Monetary cost of sales 3,085 2,422 9,826 7,479
Nonmonetary cost of sales 555 397 1,437 1,723
------------------ ------------------ ------------------ ------------------
Total cost of sales 3,640 2,819 11,263 9,202
------------------ ------------------ ------------------ ------------------
Gross profit 1,190 1,641 3,798 5,147
Selling, general and administrative expenses 4,122 2,634 18,223 9,053
Amortization of intangible assets 1,236 584 3,709 1,752
Research and development expenses 783 -- 2,302 --
------------------ ------------------ ------------------ ------------------
6,141 3,218 24,234 10,805
------------------ ------------------ ------------------ ------------------
Operating loss (4,951) (1,577) (20,436) (5,658)
Interest expense 3,208 2,843 9,621 8,926
Interest income (104) (169) (640) (632)
Equity interest in losses of joint venture -- 734 -- 3,443
Gain on sale of interest in joint venture -- -- -- (74,977)
Other expense (income) -- 110 (2) 214
------------------ ------------------ ------------------ ------------------
Net income (loss) before extraordinary item (8,055) (5,095) (29,415) 57,368
Extraordinary item - gain on extinguishment
of debt -- 1,709 -- 4,239
------------------ ------------------ ------------------ ------------------
Net income (loss) (8,055) (3,386) (29,415) 61,607
Preferred stock dividends (difference
on conversion of preferred stock,
net of dividend) 4 (1,763) 1,433 (5,643)
------------------ ------------------ ------------------ ------------------
Net income (loss) attributable to common
stockholders $ (8,059) $ (1,623) $ (30,848) $ 67,250
================== ================== ================== ==================
Other comprehensive income (loss):
Unrealized loss on available for
sale securities -- (332) -- (61,799)
------------------ ------------------ ------------------ ------------------
Comprehensive Income $ (8,059) $ (1,955) $ (30,848) $ 5,451
================== ================== ================== ==================
Basic and diluted net loss per common share:
Basic:
Net income (loss) before extraordinary item
per common share $ (0.60) $ (0.19) $ (2.32) $ 3.79
Extraordinary item $ -- $ 0.10 $ -- $ 0.25
------------------ ------------------ ------------------ ------------------
Net loss attributable to common stockholders $ (0.60) $ (0.09) $ (2.32) $ 4.04
================== ================== ================== ==================
Weighted average basic common shares
outstanding: 13,499 17,451 13,285 16,648
================== ================== ================== ==================
Diluted:
Net income (loss) before extraordinary item
per common share $ (0.60) $ (0.19) $ (2.32) $ 3.63
Extraordinary item $ -- $ 0.10 $ -- $ 0.24
------------------ ------------------ ------------------ ------------------
Net loss attributable to common stockholders $ (0.60) $ (0.09) $ (2.32) $ 3.87
================== ================== ================== ==================
Weighted average diluted common shares
outstanding: 13,499 17,451 13,285 17,353
================== ================== ================== ==================
</TABLE>
See accompanying notes to Consolidated Financial Statements
6
<PAGE> 7
SOURCE MEDIA, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, 1999 SEPTEMBER 30, 2000
------------------ ------------------
<S> <C> <C>
OPERATING ACTIVITIES
Net income (loss) $ (29,415) $ 61,607
Adjustments to reconcile net income (loss) to net cash used in
operating activities:
Depreciation 2,032 1,337
Amortization of intangible assets 3,709 1,753
Deferred Compensation 894 1,077
Non-cash interest expense 619 857
Non-cash interest income (296) (118)
Provision for losses on accounts receivable 250 (47)
Gain on sale of joint venture -- (74,977)
Equity investment in losses of joint venture -- 3,443
Extraordinary gain on issuance of common stock in exchange for notes (4,239)
Changes in operating assets and liabilities:
Trade accounts receivable 1,854 116
Related party receivable -- 985
Prepaid expenses and other current assets (436) (171)
Deferred expenses (54) 15
Trade accounts payable and accrued liabilities 4,915 1,230
Accrued interest (43) (23)
Unearned income 602 (14)
------------------ ------------------
Net cash used in operating activities (15,369) (7,169)
INVESTING ACTIVITIES
Capital expenditures (1,166) (99)
Redemption of investments -- 5,775
Redemption of short-term investments 6,000 2,500
Proceeds from sale of joint venture -- 4,392
Investment in SourceSuite LLC -- (4,392)
------------------ ------------------
Net cash provided by investing activities 4,834 8,176
FINANCING ACTIVITIES
Proceeds from issuance of common stock 3,315 1,009
Warrants exercised 1,164 244
Other 162 1
------------------ ------------------
Net cash provided by financing activities 4,641 1,254
------------------ ------------------
Net increase (decrease) in cash and cash equivalents (5,894) 2,261
Cash and cash equivalents at beginning of period 11,662 10,910
------------------ ------------------
Cash and cash equivalents at end of period $ 5,768 $ 13,171
================== ==================
</TABLE>
See accompanying Notes to Consolidated Financial Statements
7
<PAGE> 8
SOURCE MEDIA, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (CAPITAL DEFICIENCY)
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
COMMON STOCK CAPITAL IN
--------------------------- TREASURY EXCESS OF ACCUMULATED
SHARES AMOUNT STOCK PAR VALUE DEFICIT
------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
BALANCE AT DECEMBER 31, 1999 16,278 $ 16 $ (2,647) $ 120,883 $ (187,124)
Issuance of common stock upon exercise of
stock options 109 -- -- 837 --
Issuance of stock for employee stock plan -- -- 171 -- --
Stock compensation -- -- -- 1,077 --
Net income -- -- -- -- 61,607
Preferred stock exchange 725 1 -- 4,398 --
Warrants exercised 83 -- -- 244 --
Accumulated other comprehensive loss -- -- -- -- --
Issuance of common stock for note exchange 674 1 -- 3,468 --
Preferred stock dividends -- -- -- 5,643 --
------------ ------------ ------------ ------------ ------------
BALANCE AT SEPTEMBER 30, 2000 17,869 $ 18 $ (2,476) $ 136,550 $ (125,517)
============ ============ ============ ============ ============
<CAPTION>
TOTAL
STOCKHOLDERS'
COMPREHENSIVE EQUITY (CAPITAL
LOSS DEFICIENCY)
------------ ------------
<S> <C> <C>
BALANCE AT DECEMBER 31, 1999 $ -- $ (68,872)
Issuance of common stock upon exercise of
stock options -- 837
Issuance of stock for employee stock plan -- 171
Stock compensation -- 1,077
Net income -- 61,607
Preferred stock exchange -- 4,399
Warrants exercised -- 244
Accumulated other comprehensive loss (61,799) (61,799)
Issuance of common stock for note exchange -- 3,469
Preferred stock dividends -- 5,643
------------ ------------
BALANCE AT SEPTEMBER 30, 2000 $ (61,799) $ (53,224)
============ ============
</TABLE>
See accompanying Notes to Consolidated Financial Statements
8
<PAGE> 9
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 operating
subsidiaries ("Subsidiaries"), including IT Network, Inc. ("IT Network"),
Interactive Channel, Inc. ("Interactive Channel"), and SMI Holdings, Inc., its
other operating subsidiary, Interactive Channel Technologies Inc., ("ICTI"), as
well as its wholly-owned non-operating subsidiary, Source Nevada, Inc., and
SourceSuite LLC ("SourceSuite"), a 50/50 joint venture with Insight Interactive
LLC ("Insight"), a subsidiary of Insight Communications Company, Inc.
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 and nine months ended September 30, 2000 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2000. The balance sheet at December 31, 1999 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, 1999.
On March 3, 2000 Source Media and Insight sold their respective
interests in a joint venture to Liberate Technologies ("Liberate") in exchange
for the issuance of 886,000 shares of common stock of Liberate and $4.4 million
of cash to each of Source Media and Insight. Prior to the sale of the joint
venture, cash equal to the value (as determined by an independent appraisal) of
certain retained businesses, consisting of the interactive programming guide and
related content business, was contributed by the joint venture to SourceSuite,
of which Source Media and Insight each own 50%. SourceSuite used these funds to
purchase the retained businesses from the joint venture, which were comprised of
fixed assets with a net book value of approximately $200,000 and certain accrued
liabilities, for $1.1 million.
9
<PAGE> 10
The following represents the unaudited pro forma results of operations
of Source Media as if the joint venture with Insight and subsequent sale to
Liberate had occurred on January 1, 1999.
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended Nine Months Ended
September 30, 1999 September 30, 1999 September 30, 2000
------------------ ------------------ ------------------
<S> <C> <C> <C>
Total revenues 4,830 15,020 14,349
Operating loss (2,353) (12,382) (5,658)
Net income (loss) attributed to
common stockholders (5,993) (24,787) 68,336
Net income (loss) per common share (0.44) (1.87) 3.85
</TABLE>
2. Equity Investment in Joint Venture
The Company recorded its share of results of operations of its original
joint venture with Insight up to March 3, 2000 and records its share of
operating results of SourceSuite using the equity method in the Consolidated
Statement of Operations. The Company owns a 50% interest in SourceSuite, which
provides SourceGuide, an interactive programming guide; LocalSource, an
interactive television programming service; and is developing other applications
for the interactive television industry. SourceSuite is managed by the Company
within the terms of the operating agreement and the annual operating plan
approved by the management committee. Special actions by SourceSuite require
approval of a four-member management committee comprised of two representatives
from each of Source Media and Insight. The Operating Agreement of SourceSuite
restricts any distribution of equity to members for a period of three years.
3. Computation of Net Income (Loss) Per Common Share
The Company computes net income (loss) per share in accordance with
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS
No. 128). Basic net income (loss) per common share is computed by dividing net
income (loss) attributed to common stockholders by the weighted average number
of common shares outstanding. In computing dilutive net income (loss) per share,
options, warrants, and convertible securities are excluded if their effect would
be antidilutive.
The reconciliation between the numerator of Basic and Diluted net
income (loss) per common share is as follows:
10
<PAGE> 11
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30, September 30, September 30,
------------- ------------- ------------- -------------
1999 2000 1999 2000
---- ---- ---- ----
<S> <C> <C> <C> <C>
Numerator for both basic and diluted
net income (loss) per share:
Net income (loss) before extraordinary
items (8,055) (5,095) (29,415) 57,368
Extraordinary items -- 1,709 -- 4,239
Preferred dividend (4) 1,763 (1,433) 5,643
-------- -------- --------- -------
Income (loss) available to
common stockholders $(8,059) $(1,623) $(30,848) $67,250
======== ======== ========= =======
</TABLE>
The reconciliation between the denominator of Basic and Diluted net
income (loss) per common share is as follows:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30, September 30, September 30,
------------- ------------- ------------- -------------
1999 2000 1999 2000
---- ---- ---- ----
<S> <C> <C> <C> <C>
Denominator for basic net income
(loss) per share - weighted average
shares 13,499 17,451 13,285 16,648
Effect of dilutive securities:
Employee stock options -- -- -- 141
Warrants -- -- -- 564
------------- ------------- ------------- -------------
Dilutive potential common shares -- -- -- 705
Denominator for diluted net
income (loss) per share -
adjusted weighted average shares
and assumed conversions 13,499 17,451 13,285 17,353
============= ============= ============= =============
Basic:
Net income (loss) per share
before extraordinary item $ (0.60) $ (0.19) $ (2.32) $ 3.79
Extraordinary gain -- 0.10 -- 0.25
------------- ------------- ------------- -------------
Net income (loss) attributable to
common stockholders $ (0.60) $ (0.09) $ (2.32) $ 4.04
============= ============= ============= =============
Diluted:
Net income (loss) per share
before extraordinary item $ (0.60) $ (0.19) $ (2.32) $ 3.63
Extraordinary gain -- 0.10 -- 0.24
------------- ------------- ------------- -------------
Net income (loss) attributable to
common stockholders $ (0.60) $ (0.09) $ (2.32) $ 3.87
============= ============= ============= =============
</TABLE>
11
<PAGE> 12
4. Available for Sale Securities
Investment in securities available for sale is recorded at market value
as of the reporting date. Temporary declines in market value are charged to
shareholders' equity. Other than temporary declines in market value, if any, are
charged to earnings. The closing price per share of the Liberate common stock at
September 29, 2000 was $28.9375 resulting in an aggregate value of $25.6
million. The decline from the previous quarter has been reflected in other
comprehensive income and charged to Shareholder's equity. Management does not
currently believe the decline in market value of the Liberate common stock to be
other than temporary.
5. New Accounting Pronouncements
Financial Accounting Statement ("FAS") 133, Accounting for Derivative
Instruments and Hedging Activities was issued in June 1998, and amended by FAS
137 and FAS 138 to be effective for all fiscal quarters of fiscal years
beginning after June 15, 2000. The Company has not yet adopted or completed its
assessment of the implications of this statement. The Company is also
considering the effects of the SEC Staff Accounting Bulletin No. 101, Revenue
Recognition ("SAB 101") that is to be effective no later than the fourth fiscal
quarter of fiscal years beginning after December 15, 1999. If the Company were
to change its current revenue recognition methodology in accordance with SAB
101, the Company would expect this change in accounting policy to have a
negative impact on fourth quarter revenues, but to have a positive revenue
effect for the full year 2000. Net income for the year would decrease due to the
impact of the cumulative effect of the accounting change. Additionally, the
Company has completed its evaluation of the effects of FASB Interpretation 44,
Accounting for Certain Transactions Involving Stock Options ("FIN 44") and
believes that the Company is in compliance with FIN 44.
6. Commitments and Contingencies
On August 21, 1998, the first of fourteen class action complaints were
filed against the Company and certain of its present and former 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
of 1934 and Rule 10-b5 promulgated thereunder. The fourteen complaints were
consolidated into the first filed case. Plaintiffs filed an amended complaint on
March 3, 1999. The plaintiffs sought damages in an unspecified amount. On May 1,
2000, the Court set a series of deadlines for the disposition of the case with
the trial set for April 16, 2001. The Company believes this case is totally
without merit and intends to vigorously defend itself and its officers and
directors.
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, if determined adversely to the Company, are not expected to have a
material adverse affect on the Company. Further, the Company is involved in
routine litigation in the ordinary course of business, none of which, either
singly or in the aggregate, if determined adversely to the Company, is expected
to have a material adverse effect on the Company's results of operations or its
financial condition.
12
<PAGE> 13
The Company has employment agreements with five senior executives which
expire in 2001 and 2002. The agreements generally provide that the Company will
pay a base salary amount and grant stock options to the employees, which vest
over a fixed period, typically four years. In the event of a termination without
cause, the Company remains obligated to make certain payments as defined in the
agreements.
7. 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
of the Notes, representing funds sufficient, together with interest thereon, to
pay the first four interest payments on the Notes. Additionally, $6.0 million
from the proceeds received in a transaction with Insight was placed into escrow
and used to pay the May 2000 interest payment. The November 2000 interest
payment was made from available cash funds.
The Notes are fully and unconditionally guaranteed, jointly and
severally, by all 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 the
capital stock of its subsidiaries, investments in Liberate and SourceSuite, and
the remaining invested proceeds from the issuance of the Notes and the Preferred
Stock and related warrants and Insight Communication Company Inc.'s equity
investment. Financial statements for the Subsidiary Guarantors and Source Media,
Inc., on an unconsolidated basis, are not presented because management has
determined that they would not be material to investors. In conjunction with the
formation of SourceSuite, the Company pledged its membership units in
SourceSuite as collateral to secure payments on the Notes. On December 13, 1999,
$3.8 million of Notes were tendered to the Company and additional cash received
in exchange for an exercise of warrants to purchase shares of common stock.
In June and August of 2000, the Company issued 394,285 and 279,720
shares of common stock with a market value of $5.25 and $5.00 per share,
respectively, in exchange for Notes with a carrying value of $4.6 million and
$3.1 million, respectively. These transactions resulted in extraordinary gains
of $2.5 million and $1.7 million in the quarters ended June 30 and September 30,
2000, respectively. The face value of the remaining Notes was $88.5 million at
September 30, 2000.
13
<PAGE> 14
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. 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, 2000, $88.5 million of Notes were outstanding and the dealer
quoted value of a Note was $0.37 per dollar face value resulting in an aggregate
fair market value of the outstanding Notes of approximately $32.7 million.
8. 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, any dividend payment occurring on or prior to November 1, 2002, 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
Preferred Stock limits the amount of cash dividends that may be paid on the
Preferred Stock. 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.
14
<PAGE> 15
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.
During the second and third quarters, the Company entered into a number
of agreements whereby it exchanged shares of its common stock for shares of
Preferred Stock. In each instance, the exchange ratio was 1.2 common shares for
each share of Preferred Stock. The Company issued 537,744 and 187,320 shares of
common stock with a market value of $3.5 million and $0.9 million, respectively,
in exchange for Preferred Stock with a carrying value of $8.2 million and $3.0
million, respectively. Dividends on preferred shares were deducted from the
difference between the carrying value of preferred shares ($4.7 and $2.1 million
for the quarters ended June 30 and September 30, respectively) and the market
value of the common shares issued to determine the amount to be added back in
arriving at net earnings (loss) available to common shareholders.
At the time of issuance 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, 2000 the dealer-quoted
fair market value of the Preferred Stock was approximately $6.72 per share for
an aggregate value of the outstanding Preferred Stock of $3.6 million.
On February 1, May 1, and August 1, 2000, the quarterly dividends due
on the Preferred Stock were paid through the issuance of additional Preferred
Stock having a liquidation preference of $0.9 million, $0.9 million, and $0.5
million, respectively, 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, 2000 was approximately $0.4 million, $0.3
million, and $0.1 million, respectively, which were recorded as Preferred Stock
dividends.
9. Stock Based Compensation
On January 2, 1998, the Company issued stock option grants to its
employees which 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 common
15
<PAGE> 16
stockholders at the date of grant, the portion of unauthorized options were
treated as a variable compensation plan through July 28, 1998, when the
stockholders authorized the shares. Separately, in the second quarter of 2000,
the Company accelerated the vesting and modified the terms of stock options
associated with the severance of an employee which resulted in $0.6 million of
compensation expense on the new measurement date. The Company has recognized
stock compensation income of $0.3 million and expense of $0.2 million in
selling, general and administrative expense for the three months ended September
30, 1999 and 2000, respectively. Total expense amounted to $0.9 million and $1.1
million, respectively, for the nine month periods ended September 30, 1999 and
2000.
10. Equity in SourceSuite Joint Venture
On November 17, 1999 the Company completed the creation of a joint
venture with Insight to conduct the business of its former VirtualModem(TM) and
Interactive TV lines of business. The investment in the joint venture was
accounted for by the equity method. The Company contributed certain assets of
the "VirtualModem(TM)" and "Interactive Channel" products and businesses in
exchange for a 50% ownership in the joint venture. Insight contributed $13
million in cash to the joint venture in exchange for a 50% interest. On March 3,
2000, the joint venture conveyed its Interactive TV line of business to
SourceSuite and Source Media and Insight each transferred their interests in the
joint venture to Liberate in exchange for the issuance to each of Source Media
and Insight of 886,000 shares of Liberate common stock and $4.4 million of cash.
This transaction resulted in a gain for the Company of $75.0 million in
the first quarter. The gain was calculated based on the closing price of
Liberate common stock on March 3, 2000 (the closing date) of $98.6875 per share,
net of the Company's book basis of $17.4 million. The Company has net operating
loss carry forwards in excess of the tax effect of this gain and, consequently,
has reported no current or deferred income tax expense.
Assets contributed to SourceSuite have been valued based on an
independent appraisal of fair value and allocated to assets, liabilities and
goodwill.
The Company records amortization of the assets contributed to the joint
venture on its historical basis.
16
<PAGE> 17
Summary financial data of SourceSuite at September 30, 2000 is as
follows (in thousands):
<TABLE>
<S> <C>
ASSETS:
Current Assets .................................... $ 5,713
Property and equipment, net ....................... 209
Intangible assets, net ............................ 752
-------
$ 6,674
=======
LIABILITIES AND MEMBERS' EQUITY:
Current liabilities ............................... $ 1,058
Members' equity ................................... 5,616
-------
$ 6,674
=======
NET LOSS:
Net loss from period of inception (March 3, 2000)
through September 30, 2000 ....................... $(4,351)
=======
</TABLE>
11. Segment Reporting
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.
The Interactive TV business has developed 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 Interactive TV business includes the results of the
Interactive Channel and ICTI subsidiaries and the Company's 50% equity interest
in the results of SourceSuite (and its predecessor joint venture with Insight)
from November 17, 1999.
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.
17
<PAGE> 18
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1999 2000 1999 2000
---------- ---------- ---------- ----------
(In Thousands) (In Thousands)
<S> <C> <C> <C> <C>
Monetary revenues:
IT Network $ 4,275 $ 4,063 $ 13,582 $ 12,626
Interactive TV -- -- 42 --
---------- ---------- ---------- ----------
Total monetary revenues $ 4,275 $ 4,063 $ 13,624 $ 12,626
========== ========== ========== ==========
Nonmonetary revenues:
IT Network $ 555 $ 397 $ 1,437 $ 1,723
Interactive TV -- -- -- --
---------- ---------- ---------- ----------
Total nonmonetary revenues $ 555 $ 397 $ 1,437 $ 1,723
========== ========== ========== ==========
Net revenues:
IT Network $ 4,830 $ 4,460 $ 15,019 $ 14,349
Interactive TV -- -- 42 --
---------- ---------- ---------- ----------
Total net revenues $ 4,830 $ 4,460 $ 15,061 $ 14,349
========== ========== ========== ==========
Operating loss:
IT Network $ (1,617) $ (958) $ (5,372) $ (3,031)
Interactive TV (2,598) -- (8,053) --
Corporate (736) (619) (7,011) (2,627)
---------- ---------- ---------- ----------
Total operating loss $ (4,951) (1,577) $ (20,436) $ (5,658)
========== ========== ========== ==========
Equity interest in loss of joint venture:
Interactive TV $ -- $ (734) $ -- $ (3,443)
========== ========== ========== ==========
</TABLE>
<TABLE>
<CAPTION>
December 31, 1999 September 30, 2000
----------------- ------------------
<S> <C> <C>
Identifiable assets:
IT Network $15,474 $12,626
Interactive TV 20,675 --
Corporate 21,867 44,482
------- -------
Total identifiable assets $58,016 $57,108
======= =======
Investment in joint venture:
Interactive TV $18,669 $ 2,766
======= =======
</TABLE>
12. Restatement of June 30, 2000 Financial Statements
The Company has restated its financial statements for the quarter and
six months ended June 30, 2000 to reflect a previously reported gain on the
extinguishments of debt as an extraordinary item rather than as a change in
equity, and to reflect the benefit realized upon the exchange of common shares
for shares of Preferred Stock as an increase (decrease) in income (loss)
attributable to common shares. These changes increased net income for the
quarter and six months ended June 30, 2000 by $7.2 million and increased basic
income per share for the quarter and six months by $0.44 and diluted net income
per share by $0.44 and $0.42 per share for the quarter and six months,
respectively. The restatement had no effect on the Company's cash flows or
financial position.
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<PAGE> 19
13. Subsequent Events
On November 8, 2000, the Company approved the extension of the exercise
period of Warrants to purchase the Company's Common Stock. The expiration date
of the "Public Warrants," originally issued June 23, 1993 and previously
scheduled to expire December 22, 2000, was extended to December 21, 2001.
19
<PAGE> 20
SOURCESUITE LLC
BALANCE SHEET
SEPTEMBER 30, 2000
(DOLLARS IN THOUSANDS)
(UNAUDITED)
<TABLE>
<S> <C>
ASSETS
Current Assets:
Cash and cash equivalents $ 4,871
Related Party Receivable 488
Prepaid expenses and other current assets 354
----------
Total current assets 5,713
Property and equipment:
Computer and production equipment 249
Accumulated depreciation 40
----------
Net property and equipment 209
Intangible assets:
Goodwill 858
Accumulated amortization 106
----------
Net intangible assets 752
----------
Total assets $ 6,674
==========
LIABILITIES AND MEMBERS' EQUITY
Current Liabilities:
Accounts payable $ 18
Accrued liabilities 567
Payable to Source Media, Inc. 473
----------
Total current liabilities 1,058
Members' equity, 1,000,000 units authorized and
outstanding 9,967
Accumulated deficit (4,351)
----------
Total Members' Equity 5,616
----------
Total liabilities and members' equity $ 6,674
==========
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
20
<PAGE> 21
SOURCESUITE LLC
STATEMENT OF OPERATIONS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS PERIOD OF INCEPTION
ENDED (MARCH 3, 2000) TO
SEPTEMBER 30, 2000 SEPTEMBER 30, 2000
------------------ ------------------
<S> <C> <C>
Revenues $ 24 $ 24
Operating expenses:
Selling, general and administrative expenses 1,553 4,514
Amortization of intangible assets 43 106
------------------ ------------------
Total operating expenses 1,596 4,620
------------------ ------------------
Operating loss (1,572) (4,596)
Interest income 104 245
------------------ ------------------
Net loss $ (1,468) $ (4,351)
================== ==================
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
21
<PAGE> 22
SOURCESUITE LLC
STATEMENT OF CASH FLOWS
PERIOD OF INCEPTION (MARCH 3, 2000) TO SEPTEMBER 30, 2000
(DOLLARS IN THOUSANDS)
(UNAUDITED)
OPERATING ACTIVITIES
Net Loss $(4,351)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation 27
Amortization of intangible assets 106
Changes in operating assets and liabilities:
Related party receivable 599
Prepaid expenses and other current assets (312)
Trade accounts payable and accrued liabilities 84
Related party payable (66)
-------
Net cash used in operating activities (3,913)
INVESTING ACTIVITIES
Capital expenditures (48)
-------
Net cash used in investing activities (48)
-------
Net decrease in cash and cash equivalents (3,961)
Cash and cash equivalents at beginning of period 8,832
-------
Cash and cash equivalents at end of period $ 4,871
=======
See accompanying Notes to Consolidated Financial Statements.
22
<PAGE> 23
SOURCESUITE LLC
STATEMENT OF MEMBERS' EQUITY
SEPTEMBER 30, 2000
(DOLLARS IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
MEMBERSHIP MEMBERS'
UNITS EQUITY
------------- -------------
<S> <C> <C>
Sale of membership units on March 3, 2000 1,000,000 $ 9,967
Net loss -- (4,351)
------------- -------------
September 30, 2000 1,000,000 $ 5,616
============= =============
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
23
<PAGE> 24
SOURCESUITE LLC
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM INCEPTION (MARCH 3, 2000) THROUGH SEPTEMBER 30, 2000
1. DESCRIPTION OF BUSINESS
SourceSuite LLC ("SourceSuite" or "Company"), a Delaware limited
liability company, was formed on March 3, 2000 as a 50/50 joint venture between
Source Media, Inc. ("Source Media") and Insight Interactive, LLC ("Insight").
On November 17, 1999 Source Media conveyed certain assets related to
its VirtualModem(TM)" and "Interactive Channel" products and businesses and
Insight contributed $13 million in cash to a joint venture in exchange for each
owning a 50% interest in that joint venture.
On March 3, 2000, Source Media and Insight sold their respective
interests in the joint venture to Liberate Technologies ("Liberate") in exchange
for the issuance of 886,000 shares of common stock of Liberate to each of Source
Media and Insight and $4.4 million of cash. Prior to the sale of the joint
venture, cash equal to the value (as determined by an independent appraisal) of
certain retained businesses, consisting of SourceGuide, an interactive
programming guide; LocalSource, an interactive television programming service;
and related content, was contributed by the joint venture to SourceSuite.
SourceSuite used these funds to purchase the retained business from the joint
venture, which comprised of fixed assets with a net book value of approximately
$200,000 and certain accrued liabilities, for $1.1 million.
SourceSuite will continue the development of the proprietary software
contributed by Source Media and will provide interactive programming services
that are enabled on 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.
Liberate provides SourceSuite, without charge, specific software
development services for the Interactive TV products under a programming
services agreement. SourceSuite entered into a preferred content provider
agreement with Liberate pursuant to which Liberate offers pricing incentives to
its customers that use SourceSuite's local content services with the
VirtualModem(TM) products.
2. ACCOUNTING POLICIES
Basis of Presentation
Assets contributed to the joint venture by Source Media have been
valued at the fair value on the date of contribution based on an independent
appraisal and allocated to assets, liabilities and goodwill.
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<PAGE> 25
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
Cash and Cash Equivalents
The Company classifies all highly liquid investments with original
maturities of three months or less as cash equivalents. These investments are
recorded at cost, which approximates market.
Computer and Production Equipment
Computer and production equipment are recorded at cost. Depreciation is
computed using the straight-line method over the estimated useful lives (three
to five years) of the assets.
Intangible Assets
Goodwill resulted from the difference between the cash received for the
fair value of the assets contributed to the joint venture and their recorded
values. Intangible assets are amortized using the straight-line method over an
estimated useful life of five years.
The carrying value of intangible assets is reviewed for impairment
whenever events or changes in circumstances indicated that there may be an
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 fair value.
Comprehensive Income
There are no significant comprehensive income items, therefore,
comprehensive income is equal to net income and not separately shown on the
Statement of Operations.
3. INCOME TAXES
SourceSuite has experienced net operating losses from inception.
Accordingly, no provision for income taxes has been recorded. A valuation
allowance has been established to fully offset the deferred tax asset associated
with SourceSuite's net operating loss carry forwards.
4. MEMBERS' EQUITY
Distribution of equity to members is restricted by the Company's
Operating Agreement for a period of three years.
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<PAGE> 26
5. RELATED PARTY TRANSACTIONS
As part of the joint venture agreement between Source Media and
Insight, Source Media manages the day-to-day operations of SourceSuite within
the terms of SourceSuite's operating plan. As part of this arrangement,
SourceSuite reimburses Source Media for the direct costs of the Interactive TV
business and certain overhead costs. These costs have been included in the
payable to related parties and are reimbursed to Source Media on a regular
basis. Additionally, SourceSuite purchases certain hardware on behalf of
Insight. These amounts are billed to Insight and included in related party
receivables.
6. COMMITMENTS AND CONTINGENCIES
Upon formation, SourceSuite assumed the responsibility for the
following litigation:
On October 6, 1998, Advanced Interactive, Inc. filed a complaint in
U.S. District Court for the Northern District of Illinois, Eastern Division,
against ICTI 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 American,
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 "Defendants"). Advanced Interactive, Inc.
alleges that ICTI 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 Defendant for its particular product or
service. The Plaintiff seeks damages, but makes no claims against the patents of
ICTI or any other Defendant. ICTI, 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 June 26, 2000, the court
entered a judgement that ICTI does not infringe on Advanced Interactive's
patent. The Plaintiff has filed a Notice of Appeal of this judgement in the U.S.
Court of Appeals of the Federal Circuit dated August 3, 2000. This case was
transferred to the joint venture between Source Media and Insight in November
1999 and was assumed by SourceSuite on March 3, 2000. The Company is vigorously
defending the appeal.
26
<PAGE> 27
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Unless the context otherwise requires, all references to "we", "us" or
"our" include Source Media, Inc., its wholly-owned operating subsidiaries
("Subsidiaries"), including IT Network, Inc. ("IT Network"), Interactive
Channel, Inc. ("Interactive Channel"), and SMI Holdings, Inc., its other
operating subsidiary, Interactive Channel Technologies Inc. ("ICTI"), as well as
its wholly-owned non-operating subsidiary, Source Nevada, Inc., and SourceSuite
LLC, a 50/50 joint venture with Insight Interactive LLC ("Insight"), a
subsidiary of Insight Communications Company, Inc.
FORWARD LOOKING INFORMATION AND RISK FACTORS
We or our 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 our various filings with the
Securities and Exchange Commission. We wish 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.
We caution you that this list of factors does not describe all of the
risks of an investment in our common stock. We operate in a rapidly changing
business environment, and new risk factors continually emerge. We cannot predict
every risk factor, nor can we assess the impact of all these risk factors on our
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 our actual results.
Among the factors that could cause actual results to differ materially
from our expectations are our high degree of leverage and our ability to service
debt, the need for additional financing, that we may not have sufficient
collateral to repay our indebtedness in full, the potential for a change of
control that would require us to purchase our notes and Preferred Stock,
historical and projected losses, access to channels on cable television systems
and uncertainty of subscriber acceptance, the uncertainty of a market for
interactive television, the availability of programming, the further technical
development needed to improve the economics of deploying interactive television
to multiple cable systems, a delay in the roll-out of digital set-top boxes,
competition within the industry, rapid technological advances that could render
our products obsolete or non-competitive, anti-takeover effects of our
shareholder rights plan, stock volatility, the market price of our common stock,
the market price of our investments, our ability to attract and retain key
27
<PAGE> 28
management personnel, government regulation and other factors discussed from
time to time in our Annual Report on Form 10-K and other Securities and Exchange
Commission filings.
GENERAL
The following discussion should be read in conjunction with our
Consolidated Financial Statements and related notes which are included elsewhere
in this report.
We provide streaming media content and sell interactive advertising
that can be accessed over the telephone and the Internet. We also own a 50%
interest in SourceSuite LLC, a joint venture we manage, which provides
interactive cable television programming services, including a fully interactive
program guide, known as SourceGuide(TM), and an information entertainment
service, known as LocalSource(TM). We categorize these operations as our IT
Network business and our Interactive TV business.
We have experienced significant changes in our Interactive TV business
since the second quarter of 1999. In November 1999 we contributed this business
to a 50/50 joint venture with Insight. Insight contributed $13 million of equity
financing to the joint venture and purchased 842,105 shares of our common stock
for $12 million ($14.25 per share) and warrants to purchase 4,596,786 additional
shares of our common stock at $20 per share. On March 3, 2000, we and Insight
Interactive sold our interests in the joint venture to Liberate Technologies
("Liberate") in exchange for the issuance to each of us and Insight Interactive
of 886,000 shares of Liberate common stock and $4.4 million of cash. Prior to
the completion of the sale, the joint venture transferred to SourceSuite its
assets and properties not related to the VirtualModem(TM) products and
associated businesses. The interests in the new joint venture were distributed
to us and Insight Interactive, so that each became a 50% owner of SourceSuite.
Liberate thus acquired all patents and intellectual property related to the
VirtualModem(TM) products and businesses and granted SourceSuite an exclusive
license to use the patents necessary to its business. SourceSuite's business is
interactive television programming and services, including SourceGuide(TM)and
LocalSource(TM).
THREE MONTHS ENDED SEPTEMBER 30, 2000 AND 1999
Monetary revenues decreased 5% to $4.1 million for the three months
ended September 30, 2000 from $4.3 million for the same period in 1999. The
decrease was primarily driven by $0.5 million of decreased advertising sales,
$0.1 million of decreased advertiser services revenues and $0.3 million of
decreased information services revenue from the same period in the prior year.
These decreases were partially offset by $0.7 million of revenue from new
products introduced in 2000, including streaming audio sales and Internet
advertising.
Monetary cost of sales decreased 21% to $2.4 million for the three
months ended September 30, 2000 from $3.1 million for the same period in 1999,
primarily due to $0.5 million of reduced product costs due to discontinued
products and decreased sales, $0.2 million of payments in 1999 to customers for
unfulfilled sales guarantees and $0.2 million of cost of the
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<PAGE> 29
Interactive TV operations transitioned to our joint venture. These decreases
were partially offset by increases of $0.2 million of other operational
expenses.
Nonmonetary revenues and nonmonetary cost of sales decreased 28% to
$0.4 million for the three months ended September 30, 2000. Nonmonetary sales
accounted for 9% of revenues for the three months ended September 30, 2000
compared to 11% of revenues for the same period in 1999.
Selling, general and administrative expenses decreased 37% to $2.6
million for the three months ended September 30, 2000 from $4.1 million for the
same period in 1999. The decrease is primarily due to $1.3 million of cost of
the Interactive TV operations transitioned to our joint venture with Insight, a
decrease of $0.5 million in professional fees and legal fees, and other
operational savings of $0.3 million offset by an increase in non-cash variable
compensation expense of $0.6 million.
Amortization of intangible assets decreased 53% to $0.6 million from
$1.2 million for the three months ended September 30, 2000 primarily due to the
transfer of patents to our joint venture with Insight in 1999.
Research and development activities were transferred to our joint
venture with Insight in November 1999, resulting in a decrease of $0.8 million
in research and development expense compared to the three months ended September
30, 1999.
Equity interest includes our share of the results of operations of
SourceSuite for the three months ended September 30, 2000, recorded using the
equity method.
Interest expense decreased 11% to $2.8 million for the three months
ended September 30, 2000 from $3.2 million for the same period in 1999 due to
the exchange of approximately $11.5 million of Notes for common stock since
December of 1999. 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 increased 63% to $0.2 million for the three months
ended September 30, 2000 from $0.1 million for the same period 1999 due to the
investment of larger cash balances.
Extraordinary gain resulted from the gain recorded on the exchange of
$3.1 million of Notes for common stock during the third quarter.
Preferred Stock dividends reflect a benefit of $2.1 million realized on
the issuance of common stock in exchange for Preferred Stock, due to the excess
of the carrying amount of the Preferred Stock over the fair value of the
Company's common stock. This benefit is partially offset by $0.4 million of
preferred dividend expense for the three months ended September 30, 2000, as
compared to dividend expense of $4 thousand in the same period of 1999.
Excluding the benefit, the increase in dividend expense is primarily caused by a
lower Preferred Stock price in 1999. The dividends relate to the $20 million
Preferred Stock financing completed by the Company in October 1997
29
<PAGE> 30
and described in detail in the Notes to Consolidated Financial Statements.
Dividends are recorded at the fair market value of the shares.
NINE MONTHS ENDED SEPTEMBER 30, 2000 AND 1999
Monetary revenues decreased 7% to $12.6 million for the nine months
ended September 30, 2000 from $13.6 million for the same period of 1999. This
decrease is primarily due to decreases of $1.4 million in advertising sales,
$0.4 million in advertising services, and $0.9 million in information services
offset by an increase of $1.7 million in new product revenues including
streaming audio sales and Internet advertising.
Monetary cost of sales decreased 24% to $7.5 million for the nine
months ended September 30, 2000 from $9.8 million for the same period in 1999 as
a result of 1999 costs of $1.6 million for payment of unfulfilled sales
guarantees, $0.7 million of Interactive TV costs transferred to SourceSuite, and
a $0.8 million reduction in page costs related to the decreased advertising
sales partially offset by increased operational costs of $0.8 million.
Nonmonetary revenues and nonmonetary cost of sales increased 20% to
$1.7 million for the nine months ended September 30, 2000 from $1.4 million for
the same period in 1999. Nonmonetary sales accounted for 12% of revenues for the
nine months ended September 30, 2000 compared to 10% of revenues for the same
period in 1999.
Selling general and administrative expenses decreased 50% to $9.1
million for the nine months ended September 30, 2000 from $18.2 million for the
same period in 1999. The decrease is primarily due to the following: (a) $4.0
million of cost of the Interactive TV operations transitioned to our joint
venture with Insight; (b) decreased legal and professional fees of $3.1 million
which were incurred in 1999 in connection with a proposed joint venture that
were expensed after the termination of the proposed transaction; (c) a savings
of $0.4 million in severance expense in 2000; and (d) $1.6 million in cost
reductions and other administrative expenses.
Amortization of intangible assets decreased 53% to $1.7 million from
$3.7 million for the nine months ended September 30, 2000 due to the transfer of
patents to our joint venture with Insight in 1999.
Research and development activities were transferred to our joint
venture with Insight in November 1999 resulting in a decrease of $2.3 million in
research and development expense compared to the nine months ended September 30,
1999.
Other income includes $75.0 million of gain recorded upon the sale of
our interest in the original joint venture with Insight to Liberate in exchange
for 886,000 shares of common stock in Liberate and $4.4 million cash.
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<PAGE> 31
Equity interest in losses of joint venture includes our share of the
results of operations of SourceSuite and its predecessor joint venture for the
nine months ended September 30, 2000, recorded using the equity method. The
original joint venture was formed November 17, 1999.
Interest expense decreased 7% to $8.9 million for the nine months ended
September 30, 2000 from $9.6 million in 1999. This decrease is due to the
retirement of $11.5 million of Notes for common stock since December of 1999.
The interest 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 remained consistent at $0.6 million for the nine months
ended September 30, 2000.
Extraordinary gain resulted from the gain recorded on the exchange of
$7.7 million of Notes for common stock.
Preferred Stock dividends reflects a benefit of $6.8 million realized
recorded on the issuance of common stock in exchange for Preferred Stock, due to
the excess of the carrying amount of the Preferred Stock over the fair value of
the Company's common stock. This benefit is partially offset by $1.2 million of
dividend expense for the nine months ended September 30, 2000 as compared to
dividend expense of $1.4 million for the nine months ended September 30, 1999.
The dividend expense relates 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 preferred shares issued as payment-in-kind. Excluding the benefit
the decrease is related to exchanges of Preferred Stock for common stock, which
took place in the second and third quarters of this year, as well as a decrease
in the fair value of the Preferred Stock issued as dividends during the nine
months ended September 30, 2000.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, we have experienced substantial operating losses and
net losses as a result of our efforts to develop, deploy and support our IT
Network business and to develop, conduct trials and commercially launch our
Interactive TV business. As of September 30, 2000, we had an accumulated deficit
of $125.5 million and had used cumulative net cash in operations of $109.9
million. The difference at September 30, 2000, 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.
We are likely to continue to incur operating losses at least into 2001.
Any launch of our television products and services through SourceSuite may
require an additional capital contribution which may require us to raise
additional capital. On March 3, 2000, we sold our interest in the
VirtualModem(TM) business owned by our joint venture with Insight to Liberate
for 886,000 shares of Liberate common stock which became freely tradable by us
after July 31, 2000. In addition
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to the Liberate common shares, we received from Liberate $4.4 million as a
working capital adjustment which we contributed to SourceSuite. It is expected
that this liquidity will provide the necessary funding for expected future
capital requirements at least through 2000. The Liberate shares had an aggregate
value of approximately $87.4 million, based on the closing price of Liberate
common stock of $98.6875 per share on March 3, 2000. Liberate common stock is
traded on the Nasdaq Stock Market under the symbol "LBRT". As of November 7,
2000, the closing price per share of the Liberate common stock was $21.0625
resulting in an aggregate value of $18.7 million. Management does not believe
the decline in the Liberate stock price is other than temporary as there have
been no material adverse changes in Liberate's market position or balance sheet
of which management is aware. The decline in the Liberate share price appears to
closely follow the general decline of equities and, particularly, the equities
of technology companies. Additionally, Source Media believes it has adequate
cash on-hand to meet operational requirements throughout the remainder of the
year and does not expect to reduce its holding of Liberate stock in 2000.
Since inception, we have financed our operations primarily with $156.6
million raised from various financing activities, including the incurrence of
debt and issuance of our common stock and Preferred Stock. In October 1997, we
issued $100.0 million of Notes and $20.0 million of Preferred Stock. On December
19, 1999, $3.75 million of Notes were tendered to the Company and additional
cash was received in exchange for an exercise of warrants to purchase shares of
common stock. On June 20, 2000 an additional $4.6 million of Notes were
exchanged for common stock, and on August 16 and 17, an additional $1.6 million
and $1.5 million of Notes were exchanged for common stock, respectively. As of
September 30, 2000, the face value of the outstanding balance was $88.5 million.
The interest escrow account created pursuant to the indenture governing the
Notes has been 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, May 1, 1999 and November 1, 1999. Additionally, $6.0 million
from proceeds received in a transaction with Insight was placed into escrow and
used to pay the May 2000 interest payment. On November 1, 2000, we made our
interest payment of approximately $5.4 million, which was paid out of current
operating balances. Our primary source of liquidity is our cash, which totaled
$13.2 million at September 30, 2000 prior to the November interest payment.
Additionally, we have an investment of 886,000 shares of Liberate common stock
that are now freely tradeable.
We currently believe our resources will be sufficient to meet our
anticipated cash needs for working capital, required interest payments and other
capital expenditures related to the further development of our IT Network
business and capital requirements for SourceSuite through and beyond the fourth
quarter of 2000. Additionally, while we do not currently anticipate any capital
calls by the joint venture, we believe our resources are sufficient to meet any
capital calls through 2000.
Our future capital requirements will depend on many factors, including,
but not limited to the following factors, some of which are outside our control:
(i) the operating results of our IT Network business, including local
advertisers' willingness to purchase Internet based advertising; (ii) the
success and timing of the development, introduction and deployment of the
Interactive TV products; (iii) the extent of market acceptance of our products;
(iv) potential
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acquisitions or asset purchases; (v) the deployment of digital set-top boxes
incorporating technology that we are able to access; (vi) competitive factors;
and (vii) changes in the regulatory environment and (viii) general economic
conditions.
EFFECT OF INFLATION
We believe that the effect of inflation has not been material during
the three month periods ended September 30, 1999 and 2000, respectively.
NET OPERATING LOSS CARRYFORWARDS
At December 31, 1999, we had net operating loss carryforwards of
approximately $124.5 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. An ownership change occurred in 1995 that caused
utilization of $23.1 million of our net operating losses incurred prior to the
ownership change to be limited to approximately $9.0 million in a given year.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
We are exposed to changes in interest rates related primarily to our
Notes and Preferred Stock. Under our current policies, we do not use interest
rate derivative instruments to manage exposure to interest rate changes. At
September 30, 2000, we had Notes outstanding having an aggregate principal
amount of $88.5 million, due November 1, 2004, which bear interest at a fixed
rate of 12% and Preferred Stock outstanding having a liquidation preference of
$13.2 million, due November 1, 2007, which has a fixed dividend rate of 13 1/2%.
The fair value of the Notes at September 30, 2000 was approximately $32.7
million based upon dealer quoted market price. As of September 30, 2000, the
dealer-quoted fair market value of the Preferred Stock was approximately $6.72
per share for an aggregate value of the outstanding Preferred Stock of $3.6
million.
We invest our cash balance in money market funds and commercial paper
rated A1, and P1, respectively. These securities are in U.S. dollars, with
maturities of six months or less, are held to maturity and are not owned for
trading purposes. Using this strategy, we have not experienced any losses due to
interest rate risk, market risk or foreign exchange risk on our commercial paper
investments, and we do not anticipate any such losses.
On March 3, 2000, we received 886,000 shares of Liberate common stock
in exchange for our interest in our joint venture with Insight. The closing
price per share of the Liberate common stock on March 3, 2000 was $98.6875,
giving us a total original investment in Liberate common stock of approximately
$87.4 million. We face the market risk associated with price fluctuations of the
Liberate common stock until such time as we sell or hedge the stock. As of
September 30, 2000, the closing price per share of the Liberate common stock was
$28.9375 resulting in a total investment balance of $25.6 million. As of
November 7, 2000, the closing price was $21.0625, resulting in a total
investment of $18.7 million.
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PART II - OTHER INFORMATION
Item 1 - Legal Proceedings
Reference is made to our Annual Report on Form 10-K for the year ended
December 31, 1999 and to the Notes to SourceSuite's and our financial statements
included in this report for a discussion of certain litigation.
Item 2 - Changes in Securities and Use of Proceeds
We extended the exercise period of our redeemable common stock purchase
warrants, issued in June 1993, to December 22, 2001 from the previously
scheduled June 23, 2000 expiration. In addition, our right to call the warrants
for redemption may now be exercised if the closing price of our common stock is
$13.00 or more for 10 consecutive trading days.
On August 9, 2000, we issued the following stock options to various
employees pursuant to our 1999 Stock Option Plan:
<TABLE>
<CAPTION>
Number of Shares Exercise Price
Underlying Options Per Share
------------------ --------------
<S> <C>
125,000 $ 6.890
50,000 5.235
5,000 8.425
1,500 5.328
1,500 5.078
</TABLE>
Exemption from registration under the Securities Act of 1933 is claimed
for each such issuance of securities in reliance upon the exemption afforded by
Section 4(2) of the Securities Act.
Item 6 - Exhibits and Reports on Form 8-K
(a) Exhibits
10.1 Employment Agreement dated as of September 1, 2000, between
the Company and Paul Tigh
10.2 Employment Agreement dated as of September 20, 2000, between
the Company and Philip Howort
10.3 Employment Agreement dated as of October 17, 2000, between
the Company and Derrick Horner
Exhibit 27 - Financial Data Schedule
(b) Reports on Form 8-K during the three months ended September 30,
2000.
None.
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SIGNATURE
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 14, 2000 By: /s/ PAUL TIGH
-------------------------------------
Paul Tigh
Chief Financial Officer and Treasurer
(Principal Financial Officer and
Duly Authorized Officer)
<PAGE> 37
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<S> <C>
10.1 Employment Agreement dated as of September 1, 2000, between the Company and
Paul Tigh
10.2 Employment Agreement dated as of September 20, 2000, between the Company
and Philip Howort
10.3 Employment Agreement dated as of October 17, 2000, between the Company and
Derrick Horner
27 Financial Data Schedule
</TABLE>
