Item 1. Business.
General
Excelligence Learning Corporation, a Delaware corporation (“Excelligence” or the “Company”), was formed on November 6, 2000 for the purpose of effecting the combination (the “Combination”) of Earlychildhood LLC, a California limited liability company (“Earlychildhood”), and SmarterKids.com, Inc., a Delaware corporation (“SmarterKids.com”), which was completed on April 30, 2001. As more fully described herein, the Company’s Early Childhood segment is conducted primarily through its direct wholly-owned subsidiaries Earlychildhood and Marketing Logistics, Inc., a Minnesota corporation dba Early Childhood Manufacturers’ Direct (“ECMD”), and its Elementary School segment is conducted through Educational Products, Inc. (“EPI”), a Texas corporation and a wholly-owned subsidiary of Earlychildhood.
The following discussion relates to the businesses of Excelligence, which are comprised primarily of the businesses conducted by Earlychildhood, ECMD and EPI. For convenience, the terms “Company,” “Excelligence,” “we,” “our” and “us” are used in this report to refer to Excelligence and its subsidiaries collectively after giving effect to the acquisition of SmarterKids.com in April 2001, unless the context requires these terms to refer to Excelligence individually.
Corporate Website
The Company makes available its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports on its corporate website, free of charge, to individuals interested in acquiring such reports. The reports can be accessed at www.excelligencelearning.com as soon as reasonably practicable after they are electronically filed with the Securities and Exchange Commission (the “Commission” or “SEC”).
Company Overview
The Company is a developer, manufacturer and retailer of educational products, which are sold to child care programs, preschools, elementary schools and consumers. The Company serves early childhood professionals, educators and consumers by providing quality educational products and programs for children from infancy to 12 years of age. With its proprietary product offerings, a multi-channel distribution strategy and extensive management expertise, the Company aims to foster children’s early childhood and elementary education.
During fiscal year 2005, the Company operated in two business segments, Early Childhood and Elementary School, each of which is described below. Financial information, including revenues from external customers, a measure of profit or loss and total assets, for each segment of the Company for each of the last three fiscal years is contained in the Company’s financial statements listed on the accompanying Index to Consolidated Financial Statements, set forth on page, which are incorporated herein by reference.
Early Childhood Segment. The Company’s Early Childhood segment includes the brand names Discount School Supply (“DSS”), ECMD and Earlychildhood NEWS. Through its Early Childhood segment, the Company develops, markets and sells educational products through multiple distribution channels primarily to early childhood professionals and, to a lesser extent, consumers. Through this segment, the Company also provides information to teachers and other education professionals regarding the development of children from infancy through age eight.
Under the brand name Discount School Supply, the Company manufactures, imports and sells Company-developed and third-party products focused on the early childhood market. The Company sells a wide variety of early childhood products in the following categories: active play, arts and crafts, carpets, dramatic play, furniture, infant and toddler, language, manipulatives, math, music, puzzles, sand and water, science and teacher resources.
The principal component of the Discount School Supply product line is its comprehensive arts and crafts product offerings. Anchored by its Company-developed lines of art materials, BioColor® and Colorations®, DSS provides a wide variety of arts and crafts, art materials and accessories for use throughout the early childhood market. DSS also distributes third-party products, including brand names such as Crayola®, Lego®, and Elmer’s®.
The Discount School Supply catalog has been the Company’s primary vehicle for customer acquisition and sales in its Early Childhood segment. The Discount School Supply catalog is distributed twice annually to a growing customer base of education professionals, schools and consumers. Refresher versions of the catalogs are typically distributed 45 to 75 days after the initial distributions. In addition, the Company frequently sends targeted mailings to specific customer groups. The distribution of multiple catalogs enables the Company to adjust pricing and product strategies faster than competitors that distribute catalogs less frequently, and allows the Company to develop more consistent customer contact than its competitors. Discount School Supply catalogs contain projects and curriculum ideas for using the Company’s products that are designed to assist customers in educating children and improving their learning process. This educational content enables the Company to position the Discount School Supply catalog not only as a sales tool, but also as a learning resource for education professionals, teachers and consumers. It also supports an extended useful life for the catalog that competing catalogs that only sell products may not be able to attain. In the fiscal year ended December 31, 2005, the Company distributed over 2.7 million Discount School Supply catalogs. In addition, the Company mailed a specialty catalog, focused on its arts and crafts product category.
The Company has warehouses located across the United States in order to optimize shipping and delivery efficiencies and to permit delivery of an order from the Discount School Supply catalog within two business days to over 90% of its customers. See “Item 2. Properties.” During fiscal year 2005, the Company achieved a greater than 98% success rate in shipping orders that were placed by 2:00 p.m., customer’s local time, on the same day. The Company believes that its ability to ship and deliver its products in a timely manner has been a consistent competitive differentiator.
ECMD is the Company’s primary vehicle for the sale of early childhood furniture and equipment. When the Company acquired ECMD in February 2003, it was an internet-only business. However, because of the Company’s focus on catalog sales, in addition to rebuilding ECMD’s website, it created an ECMD catalog for distribution to a customer base of early childhood professionals. The Company believes that the ECMD catalog, which groups like items from different vendors to facilitate comparison, offers the largest selection of furniture and equipment in one catalog in the early childhood market. In fiscal year 2005, the Company distributed an aggregate of approximately 900,000 ECMD catalogs in mailings throughout the year.
Earlychildhood NEWS is the Company’s award-winning print and web-based magazine focused on the growth and development of children from infancy through age eight. Earlychildhood NEWS offers information, curriculum and educational programs primarily to teachers and was published in print form six times in 2005. The most recently published version was mailed to approximately 50,000 readers. Earlychildhood NEWS is also published continuously online at www.earlychildhoodnews.com and is available to early childhood professionals free of charge. Readers of Earlychildhood NEWS online may participate in sharing boards, browse a reading room of selected articles and ask questions which are answered by early childhood experts, pediatricians and child psychologists. The objective of Earlychildhood NEWS is to bring teachers together to share information, ideas and products.
Earlychildhood NEWS sponsors Newslink, a weekly opt-in e-mail program that brings its subscribers a collection of topical articles gathered from an array of news media. In addition, Newslink includes seasonal crafts and product information linked to the Earlychildhood NEWS website. In 2005, Earlychildhood NEWS also continued its sponsorship of a Professional Development Program through the University of Wisconsin-Stout, home of the nation’s second largest early childhood education program. Through the Professional Development Program, early childhood educators are able to improve their professionalism and to keep their credentials
current. Since the Professional Development Program started in 1995, over 14,000 teachers have participated in the program. The Professional Development Program reinforces the Company’s position as a resource for educational information and products. In addition, Earlychildhood NEWS sponsors Teacher QuickSource®, a web-based solution for educators in Head Start programs that relates activities and products to Head Start’s assessment structure.
Elementary School Segment. The Company’s Elementary School segment sells school supplies and other products specifically targeted for use by children in kindergarten through sixth grade, to elementary schools, teachers and other education organizations. Those parties then resell the products either as a fundraising device for the benefit of a particular school, student program or other community organization, or as a service project to the school.
Through its Elementary School segment, the Company offers products and programs to support several different fundraising alternatives, including sales programs of traditional items such as gift-wrap or candy, as well as its Company-developed product, the SchoolWrapPac®. SchoolWrapPacs® are school supply sets individually packaged to the specifications of teachers in each grade and are designed to meet the needs of their classrooms. The Company primarily sells SchoolWrapPacs® to parent teacher organizations, or PTOs, which then resell the product to parents as a fundraising activity or as a service to the school. This program can provide parents and teachers with a convenient and cost-effective way to purchase school supplies, while simultaneously supporting the school’s fundraising efforts. During the 2005 back-to-school season, the Company sold approximately 920,000 SchoolWrapPacs®, which generated approximately 88% of the Elementary School segment’s revenues for the fiscal year ended December 31, 2005.
Industry Overview
The Company’s business is concentrated in the educational products industry. The educational products industry consists of the sale of educational school supplies (excluding textbooks), furniture and equipment to school districts, individual schools, childcare programs and teachers who purchase products for school and classroom use.
The size of the preschool and elementary school-age population and levels of student enrollment fundamentally drive the demand for educational products. Figures released by the U.S. Department in fall 2005 show that total elementary and secondary school enrollment, public and private, was 55 million in fall 2002, having increased 19% from fall 1989 and the highest such figure recorded. Between 2002 and 2014, the U.S. Department of Education estimates a further aggregate increase of 4%. The U.S. Department of Education also estimates that enrollment in kindergarten through eighth grade will be 37.3 million by 2007.
The U.S. Department of Education further projects that the preprimary school-age population (consisting of children ages three to five) will be approximately 11.6 million by 2007. According to the U.S. Department of Education’s National Center for Education Statistics (NCES), which is the primary federal entity for collecting and analyzing data related to education in the United States, preprimary education is growing substantially. NCES statistics have been cited as showing that approximately 38.4 million children were to be enrolled in pre-kindergarten through eighth grade in 2005, with 33.5 million in public schools and 4.9 million in private schools. NCES estimates that an additional 2.2 million elementary students are expected in public schools by 2014, reflecting a 6% increase over fall 2005. The population of preprimary children enrolled in school programs is also projected to grow. NCES statistics indicate that, in 2003, 42% of three-year-old children were enrolled in a preprimary school program, compared to 34% in 1994. Similarly, the proportion of four-year-olds in preprimary programs during the same period increased from 60% to 68%. According to the National School Supply and Equipment Association, a not-for-profit international trade organization serving the school market, less than half of U.S. children under age five are currently served by early childhood centers and school-based pre-kindergarten programs; as the numbers of children in such centers and programs increases, demand for the Company’s products should correspondingly increase.
One of the significant drivers of enrollment of children in early childhood care and education programs is the increasing number of parents in the workforce. In September 2002, the National Child Care Association, a professional trade association focused exclusively on the needs of licensed, private childhood care and education programs, released the results of a study showing that 85% of fathers and over 50% of mothers with preschool-aged children (five years or younger) were in the labor force. The Bureau of Labor Statistics (BLS) projects that women will represent 48% of the total workforce by 2007, compared to 46.5% in 2000. Further, the BLS projects that parents will comprise 85% of the total labor force by 2010. The Women’s Bureau of the U.S. Department of Labor projects that women will comprise 47% of the total labor force in 2012, accounting for 55% of the increase in the total labor force growth from 2002 to 2012. The Company believes that this trend also indicates that the educational products industry will continue to experience significant demand in coming years.
The demand for educational products is also driven by expenditures on childcare services. In addition to private funding, both federal and state funding support childcare and early childhood education initiatives. President George W. Bush’s “No Child Left Behind Act” continues to emphasize spending on K-12 education, although the final fiscal year 2006 federal spending plan fell short of the 2005 level. Slight increases to K-12 education’s two largest programs-Title 1 and Special Education-were lost in the passing of a separate defense bill. Overall, the U.S. Department of Education’s discretionary spending level is expected to see a reduction of $624 million from fiscal 2005; however, overall discretionary spending should ultimately increase, with the addition of $1.6 billion in Hurricane Katrina relief aid included in the defense spending bill. Although the budget for Title 1 grants, which provide assistance to improve the teaching and learning of children in high-poverty schools, is budgeted to decrease $28 million from 2005, the 2006 budget nevertheless includes $12.7 billion for these grants.
Despite this static spending at the federal level, state governments are becoming increasingly involved in early childhood programs. According to Pre-K Now, a public educational and advocacy organization that advances high-quality, voluntary pre-kindergarten of all three- and four-year-olds and is supported by The Pew Charitable Trusts, pre-kindergarten received over $600 million new dollars during 2005 from state legislatures. This was the largest single-year increase in pre-kindergarten funding during the last five years, and brings cumulative spending during that period to over $14 billion. Pre-kindergarten allocations increased in 26 states and the District of Columbia, with only New Jersey and Vermont logging slight decreases. Increases ranged from less than 1% to 250%, with ten states showing increases in excess of 30%. According to the second preschool “yearbook” published in November 2004 by the National Institute for Early Education Research (NIEER), a nonpartisan, research-based institute at Rutgers University’s Graduate School of Education that supports early childhood education initiatives, enrollment in state-financed preschool programs continues to rise nationwide, although access to such services varies greatly from state to state. According to a study published by the Wilson Marketing Group, a California-based market research and database management company, state funding for pre-kindergarten is continuing on an uphill trend, growing 12.3% in fiscal 2006 on top of 12.5% growth in fiscal 2005. Pre-kindergarten spending will total almost $4.2 billion in fiscal year 2006, again increasing by a higher rate than K-12 education, which is budgeted to grow by 6.0%. For four of the last six years, state pre-kindergarten funding has increased at a dramatically higher rate than state K-12 funding. From 2000 to 2005, state spending for pre-kindergarten increased 71%, compared to a 28% increase in state spending for K-12 education. The Company believes that these increases in state pre-kindergarten spending indicate a trend towards greater access to pre-kindergarten programs for more American children, which could increase demand for the Company’s products.
The Company acknowledges that budgeted spending by state and federal governments or agencies is only planned and may not ultimately become real expenditures. However, the Company believes that continuing and increasing emphasis by state and federal governments on the importance of early childhood care and education and on education in general should result in planned expenditures being made.
Academic research continues to highlight the importance of learning in early age groups (ages one through seven) and the media’s increased focus on the importance of parental involvement during this critical stage of
growth and brain development. Researchers from NIEER released a study in December 2005 that persuasively argues for opening preschool programs to all children, instead of targeting services only to children from disadvantaged families.
Increased emphasis by state and federal governments is evident in generally consistent spending on the federal level and higher spending at the state level, as well as future plans to create more programs in more states. More programs will require more classrooms and more educators involved in early childhood education. With thousands of educational products to choose from and few reliable sources of information regarding those products, educators and administrators are faced with the challenge of finding quality educational products and selecting the right products for their programs. Through the Company, education professionals have access to comprehensive and trusted educational content and product information to help them make informed purchase decisions to better children’s learning.
Products and Services
The Company provides educational products and offers a variety of services to teachers, other education professionals and consumers. The Company combines its expertise in children’s education with the sale of Company-developed products and a diverse selection of third-party products to provide education professionals and consumers with information, ideas and products. Through its various distribution channels, the Company has streamlined merchandising and distribution of its products and more efficiently offered its services to ensure that customers can access the Company’s products conveniently and effectively. To promote and sell its products, the Company relies on its wide-scale distribution of its Discount School Supply, ECMD and specialty catalogs, its presence at industry trade shows, its national sales force and its Discount School Supply, ECMD and Earlychildhood websites.
Original Company-Developed Products. The principal component of the Company’s product line is its comprehensive arts and crafts product offerings. Anchored by its BioColor® and Colorations® product lines, the Company provides a wide variety of arts and crafts materials and accessories to children throughout the early childhood market. The Company also sells SchoolWrapPacs® to the elementary school market, which are in turn resold primarily through PTOs for service or fundraising programs.
Broad Selection of Third-Party Products. In addition to its Company-developed products, the Company offers a broad assortment of carefully reviewed and selected third-party educational products, including brand names such as Crayola®, Lego®, and Elmer’s®. These products enhance the Company’s product offerings, allowing the Company to reach teachers and other education professionals looking for a diverse range of products to fulfill the educational needs of the children in their classrooms. The Company is continually updating its product line based on customer responses and feedback monitored by its sales force and merchandising and product development specialists.
Careful Selection and Review of Educational Products. The Company only sells products that meet its quality standards. The Company consults with certified educators who assist the Company in selecting quality products that have educational or developmental value. Once selected, each product is put through a review process to determine its suitability based on the skills taught, effectiveness in addressing each skill, and the appropriate grade level(s).
Workshops, Product Demonstrations and Activities. The services offered by the Company include a variety of workshops presented by its sales force to educators, product demonstrations to PTOs and schools and archives of developmentally appropriate activities for children on each of its websites, in each case provided to enable teachers and other consumers to make easier and more effective use of the Company’s products.
The following classes of similar products accounted for 10% or more of the Company’s total revenues during the fiscal year ended December 31, 2005, 2004 and 2003: arts and crafts products, which accounted for
32.6%, 31.0% and 33.0% of the Company’s total revenues during 2005, 2004 and 2003, respectively; furniture, which accounted for 23.9%, 23.0% and 18.0% of the Company’s total revenues during 2005, 2004 and 2003, respectively; and SchoolWrapPacs®, which accounted for 19.8%, 22.0% and 26.0% of the Company’s total revenues during 2005, 2004 and 2003, respectively. The Company’s arts and crafts products and furniture are sold through the Early Childhood segment, while the SchoolWrapPacs® are sold through the Elementary School segment.
Marketing and Sales
The Company utilizes three primary channels to market and promote its products:
Catalogs. Catalogs represent the Company’s primary outreach channel and are the most important component of the Company’s customer acquisition and branding efforts. Unlike most of its main competitors who send out only one principal catalog per year, the Company distributes several catalogs per year (with redistributions of selected catalogs in different covers in between new catalogs) under its Discount School Supply and ECMD brand names. Distributing multiple catalogs per year provides the Company with flexibility to calibrate pricing to customer response rate, to contact with variable frequency different customer segments, as well as to add to or delete from the product selection. The Company distributed over 2.7 million Discount School Supply catalogs and approximately 900,000 ECMD catalogs during the fiscal year ended December 31, 2005.
Sales Representatives. As of December 31, 2005, the Company’s sales force consisted of 59 sales representatives. Of those representatives, 21 members acted as education consultants focused on catalog sales through the Company’s Early Childhood segment, and 38 focused on sales through the Company’s Elementary School segment. The Early Childhood segment’s sales representatives promote Company-developed products, such as the BioColor® and Colorations® lines, and programs, such as Earlychildhood NEWS, to teachers and administrators through in-school demonstrations and workshops that are designed to elicit higher customer response and better retention rates. Within the Elementary School segment, sales representatives educate PTOs and teachers about the benefits and convenience associated with SchoolWrapPacs® and the Company’s other fundraising programs and products.
Online Marketing. The Company’s Earlychildhood website at www.earlychildhood.com has been designed to be one of the principal vehicles used by the Company to reach customers and provide them with an array of information and services related to the Early Childhood segment’s product lines. The Earlychildhood website offers content from Earlychildhood NEWS, including authoritative articles, professional advice and sharing boards. Earlychildhood NEWS sponsors Teacher QuickSource®, a web-based solution for educators in Head Start programs that relates activities and products to Head Start’s assessment structure, which is also linked to the Earlychildhood website. The Company offers products and product-related information, recommendations and activities online through its Discount School Supply website at www.discountschoolsupply.com; that site is also linked to the Earlychildhood website at www.earlychildhood.com. In addition, the ECMD website at www.ecmdstore.com allows early childhood professionals to search a wide variety of furniture and equipment by individual vendor or by category to compare the offerings of various vendors. The Elementary School segment markets to its customers online with the EPI website at www.educationalproducts.com, which offers information about the Company’s back-to-school program, as well as its fundraising, apparel and science fair programs.
Seasonality
The Company’s seasonal sales trends coincide with the start of each school year. For the fiscal year ended December 31, 2005, approximately 43% of the Company’s consolidated annual sales were generated in the third calendar quarter. The Company’s working capital needs are greatest during the second calendar quarter as inventory levels are increased to meet seasonal demands. See “Item 1A.
Item 1A. Risk Factors.
Set forth below are certain risk factors related to the Company’s business. The risk factors described below may not include all of the risk factors that could affect future results. For example, the Company is subject to a wide array of risks that face all similarly situated companies, including its dependence on information systems, the continued service of its key employees, the impact of environmental laws, and the potential for product liability claims. Actual results could differ materially from those anticipated as a result of these and various other factors, including the following risk factors, which the Company believes are the most significant and specific risks associated with its businesses, and those set forth in the Company’s other periodic and current reports filed with the Commission from time to time. See “Forward-Looking Statements.”
The recent restatement of our previously issued financial statements has had a material adverse impact on us, including increased costs, the increased possibility of legal or administrative proceedings, and the delisting of our common stock from The Nasdaq Capital Market.
We determined that our financial statements for the fiscal year ended December 31, 2004 and for the quarter ended March 31, 2005 should be restated, as described in more detail in our Amended Annual Report on Form 10-K/A for such year and our Amended Quarterly Report on Form 10-Q/A for such quarter. As a result of these restatements, we have become subject to a number of additional risks and uncertainties, including:
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We incurred substantial unanticipated costs for accounting, legal and consultancy fees in 2005 in connection with the restatements. Although the restatements are complete, we expect to continue to incur additional costs as noted below;
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The Securities and Exchange Commission has instituted a formal investigation of the Company’s financial statements. This investigation has diverted our management’s time and attention and caused us to incur substantial costs. These investigations can also lead to fines or injunctions or orders with respect to future activities, as well as further substantial costs and diversion of management time and attention; and
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The need to complete an internal investigation and restate our previously issued financial statements caused us to be late in filing our Quarterly Reports on Form 10-Q for the quarters ended June 30, 2005 and September 30, 2005, which caused us to be delisted from The Nasdaq Capital Market in February 2006. See “Our common stock was delisted from The Nasdaq Capital Market, which may reduce the price of our common stock and the levels of liquidity available to our stockholders and cause confusion among investors” for additional discussion regarding the Nasdaq delisting.
Material weaknesses or deficiencies in our internal control over financial reporting could harm stockholder and business confidence in our financial reporting.
Maintaining an effective system of internal control over financial reporting is necessary for us to provide reliable financial reports. As disclosed in “Item 9A. Controls and Procedures” of this report and as previously disclosed in our Amended Annual Report on Form 10-K/A for the year ended December 31, 2004, our Amended Quarterly Report on Form 10-Q/A for the quarter ended March 31, 2005 and our Quarterly Reports on Form 10-Q for the second and third quarters of 2005, management’s assessment of the Company’s internal control over financial reporting identified material weaknesses related to inadequate staffing and training in the accounting function over the Company’s processing of certain financial information and improper segregation of duties over the processing and review of journal entries. We have implemented and continue to implement remediation efforts related to these material weaknesses; however, if these material weaknesses are not fully remedied or otherwise mitigated, they could result in material misstatements of the Company’s financial statements in the future. Additional restatements would materially impact our ability to timely file financial statements in the future and perceptions of us could also be adversely affected among customers, lenders, investors, securities analysts and others. Any future weaknesses or deficiencies could also hurt confidence in our business and financial statements and our ability to do business with these groups.
Our common stock was delisted from The Nasdaq Capital Market, which may reduce the price of our common stock and the levels of liquidity available to our stockholders and cause confusion among investors.
Our common stock was delisted from The Nasdaq Capital Market on February 3, 2006. Unless and until the Company’s common stock is relisted on Nasdaq, our common stock is expected to be quoted on the Pink Sheets or, if any of our current market makers file a Form 211, on the over-the-counter bulletin board. The current quotation of our common stock on the Pink Sheets may reduce the price of our common stock and the levels of liquidity available to our stockholders. In addition, the current quotation of our common stock on the Pink Sheets may materially adversely affect our access to the capital markets, and any limitation on liquidity or reduction in
the price of our common stock could materially adversely affect our ability to raise capital through alternative financing sources on terms acceptable to us or at all. Stocks that are quoted on the Pink Sheets are no longer eligible for margin loans, and a company quoted on the Pink Sheets cannot avail itself of federal preemption of state securities or “blue sky” laws, which adds substantial compliance costs to securities issuances, including pursuant to employee option plans, stock purchase plans and private or public offerings of securities. Our delisting from The Nasdaq Capital Market and current quotation on the Pink Sheets may also have other negative implications, including the potential loss of confidence by suppliers, customers and employees, the loss of institutional investor interest and fewer business development opportunities.
While we plan to apply to have our common stock relisted on The Nasdaq Stock Market, our common stock may not ultimately be relisted. Even if we are successful in getting our common stock relisted on Nasdaq, the relisting may cause confusion among investors who have become accustomed to our being quoted on the Pink Sheets as they seek to determine our stock price or trade in our stock.
We are dependent upon the size of the preschool and elementary school-age populations, levels of enrollment and expenditures per child in child care programs and elementary schools.
Our ability to grow our business depends in part on the size of the population in early childhood programs, preschools and elementary schools, the levels of enrollment of such population in child care centers and elementary schools and the level of expenditures per child in child care programs and elementary schools. The level of enrollment in early childhood programs and preschools depends in part on parents’ attitudes toward early childhood education, while the level of student enrollment in elementary schools is largely a function of demographics. Expenditures per child are a function of prevailing political and social attitudes toward education, as well as government budgets. Any significant and sustained decline in the size of the preschool and elementary school-age populations, levels of enrollment and/or expenditures per student could have an adverse effect on our business, financial condition and results of operations. See “Item 1. Business-Industry Overview.”
Our business is highly seasonal and our annual results are highly dependent on the success of our third quarter results.
We are affected by seasonal shopping patterns. A significant portion of our sales occurs in the third quarter, coinciding with the start of the U.S. school year. In the fiscal year ended December 31, 2005, we earned approximately 43% of our annual net revenues in the third quarter and operated at a net loss in the first and fourth quarters. As a result, the results of operations for our entire fiscal year depend largely on third quarter results. Factors that could cause our sales and profitability to suffer due to this seasonality include:
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the availability of and customer demand for particular products;
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unfavorable economic conditions, which decrease consumer confidence and lower consumer discretionary spending;
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the inability to purchase or maintain appropriate inventory levels, which if too low, could cause fulfillment delays of high demand product and, if too high, could leave the Company with excess inventory of unpopular products; and
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the inability to hire adequate temporary personnel in the second and third quarters.
This seasonality causes our operating results to vary significantly from quarter to quarter.
We are subject to intense competition which may impede or prevent us from attaining greater market share and could impair the growth of our revenues.
Intense competition and increased consolidation, which could result in one company’s dominance in the marketplace, may result in loss of our market share and ultimately reduce our revenues.
Our catalogs directly compete with catalogs of companies such as School Specialty, Inc., Lakeshore Learning Materials, The Kaplan Early Learning Company, U.S. Toy Company and Oriental Trading Company. There has been consolidation among our competitors over the last several years. In addition, most of our competitors have websites that compete with our websites.
We also compete, to a lesser extent, with mass-market retailers such as Target, Office Depot and Wal-Mart, other packers of school supplies such as Innisbrook, as well as retail and online booksellers and toy stores, such as Barnes & Noble, Amazon.com and Toys “R” Us. These companies have greater brand recognition and greater resources than we do. We could be at a disadvantage in responding to these competitors’ freight policies or merchandising and pricing strategies.
Our sales and profitability could suffer if, among other things:
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new competitors enter markets in which we are currently operating;
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our competitors recreate our operating strategies by pursuing an aggressive manufacturing and marketing program for a competing line of products similar to our Company-developed products;
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our competitors implement pricing strategies or freight policies that are more aggressive than ours;
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our competitors expand their operations; or
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our competitors adopt merchandising strategies similar to ours.
Restrictive loan covenants may limit our ability to draw on our credit facility, which could adversely affect our results of operations and our financial condition.
Our business is capital intensive and requires significant levels of inventory leading up to our peak business period, which we fund using our secured credit facility with Bank of America, N.A. (the “Bank of America Facility”). Effective October 1, 2005, the Company entered into an amendment extending the Bank of America Facility for $20.0 million from April 16 to October 15 of each year and $10.0 million from October 16 to April 15 of each year, through its maturity date of October 1, 2007.
As of December 31, 2005 and March 24, 2006, the Company had no outstanding borrowings under the Bank of America Facility. Available borrowing capacity as of December 31, 2005 and March 24, 2006 was $10.0 million. We cannot ensure that amounts available under the Bank of America Facility will be sufficient to fund our liquidity needs. Our ability to fund our operations, make scheduled debt payments and planned capital expenditures and to remain in compliance with financial covenants under the Bank of America Facility will depend on our future operating performance and cash flow, which in turn is subject to prevailing economic conditions and to financial, business and other factors, some of which are beyond our control.
The Bank of America Facility also includes the availability of up to $5.0 million through a reducing revolving term loan. The Bank of America Facility, which is secured by substantially all of our assets, including receivables, inventory, equipment and intellectual property, requires adherence to certain financial covenants and limitations related to capital expenditures and acquisitions during the term of the Bank of America Facility. As of December 31, 2005, the Company was not in compliance with one of the financial covenants as set forth in the Bank of America Facility.
As of December 31, 2005, the Company was in breach of the covenant set forth in Section 10.2 of the loan agreement for the Bank of America Facility. Section 10.2 of the loan agreement sets certain time limits for the delivery of quarterly financial statements and compliance certificates, which the Company was unable to deliver due to the restatement of the Company’s previously issued financial statements for the fiscal year ended December 31, 2004 and for the quarter ended March 31, 2005, and the resulting delays in finalizing the financial statements for the quarters ended June 30 and September 30, 2005. The Bank waived the Company’s breach of this covenant through February 24, 2006, and the Company was able to regain compliance within the granted extension.
If a shipment of products that we import is interrupted or delayed, our inventory levels and sales could decline.
We import some of our product offerings from foreign manufacturers. In 2005, products sourced overseas accounted for approximately 28% of the Company’s sales. These foreign manufacturers are located primarily in China, Taiwan, and Hong Kong, and, to a lesser extent, in a few European countries. We are subject to the following risks inherent in relying on foreign manufacturers:
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the inability to return products which could result in excess inventory;
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fluctuations in currency exchange rates which could potentially result in a weaker U.S. dollar in overseas markets, increasing the cost of inventory purchased;
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transportation delays and trade restrictive actions by foreign governments which could result in delays in shipping products to our customers;
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the laws and policies of the United States affecting importation of goods, including duties, quotas and taxes;
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trade infringement claims;
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increased risk of exposure from product liability claims due to uncollectibility from uninsured foreign manufacturers; and
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delays or cancellations in the manufacture or shipment of products caused by the continued threat of international terrorism, and increased security instituted in response thereto.
Interruptions or delays in our imports could cause shortages in product inventory and a decline in our sales unless we were able to secure alternative supply arrangements. Even if we could locate alternative sources, these alternative products may be of lesser quality or more expensive. Our sales could also suffer if our suppliers experience similar problems with foreign manufacturers.
We may be unable to protect our intellectual property, which could impair brand and reputation.
Our efforts to protect our proprietary rights may be inadequate. We regard our intellectual property as important to our marketing strategy. To protect our proprietary rights, we generally rely on copyright, trademark and trade secret laws, confidentiality agreements with employees and third parties and license agreements with consultants and suppliers. However, a third party could, without authorization, copy or otherwise misappropriate information from us. Furthermore, certain of our trademarks are descriptive marks that have not been and likely will not be registered with the United States Patent and Trademark Office, and third parties may use trademarks similar to ours, potentially diminishing our brand name and reputation. Employees, consultants and others who participate in development activities could breach their confidentiality agreements, and we may not have adequate remedies for any such breach. If we fail or are unable to protect our proprietary rights, it could materially decrease our value and our brand and reputation could be impaired. See “Item 1. Business-Intellectual Property.”
The cost of materials used to manufacture our products is subject to volatility, which could reduce our profitability.
The unavailability of raw materials or a substantial increase in their prices could reduce our profitability and have a negative impact on our ability to produce proprietary products. We currently sell certain Company-manufactured products, including non-toxic tempera paints, finger paints, glues and other water-based art mediums. We may, from time to time, experience difficulty in obtaining adequate raw material requirements at competitive prices, and experience shortages of raw materials used in our manufacturing process, which could reduce our profitability. In addition, the rising cost of petroleum impacts not only our inbound freight costs, but also increases our product development costs as we use various plastics in manufacturing our products. If these costs continue to rise, our manufacturing costs will continue to rise and our profitability could be reduced.
Certain of our affiliates have significant influence over us, which could limit our other stockholders’ ability to influence corporate decisions.
As of March 24, 2006, our Chief Executive Officer and two of our other stockholders owned, as of record and in the aggregate, approximately 45% of our common stock on a fully-diluted basis. As a result, these stockholders, if they were to act together, would be able significantly to influence all matters requiring approval of a majority of our stockholders, including any merger, sale of assets and other significant corporate transactions. This control could:
·
delay or prevent a change of control of the Company;
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deprive our other stockholders of an opportunity to receive a premium for their common stock as a part of a sale of the Company or its assets; and
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negatively affect the market price of our common stock.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
The Company’s corporate headquarters are located at 2 Lower Ragsdale Drive in Monterey, California. The headquarters also house the administrative functions of the Company’s Early Childhood segment. The property is leased under two separate leases, one for approximately 17,000 square feet and one for approximately 9,000 square feet. Both leases are month-to-month, requiring six months’ notice of termination. The Company does not own any real property and leases the following other materially important facilities:
Item 3.
Item 3. Legal Proceedings.
The staff in the Division of Enforcement in the San Francisco District Office of the Commission informed the Company in October 2005 that it was conducting an informal inquiry into the Company’s restatement and the related circumstances. At that time, the staff requested that the Company preserve certain documents related to this inquiry and provide on a voluntary basis certain documents to the staff for its review. The Company has cooperated with the informal inquiry and provided documents and information in response to the staff’s requests. The staff obtained a non-public formal order of investigation from the Commission in January 2006. The Company intends to continue to cooperate with the staff and Commission in connection with the formal investigation.
Aside from the above-referenced administrative proceeding, the Company and its subsidiaries are, from time to time, party to legal proceedings arising in the normal course of business. In management’s opinion, there are no pending claims or litigation, the outcome of which would have a material effect on the Company’s consolidated results of operations, financial position or cash flows.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of the Company’s security holders during the fourth quarter of 2005.
PART II.
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Throughout 2004 and 2005, the Company’s common stack was traded on The Nasdaq Capital Market. From January 1, 2004 to August 17, 2005, the Company’s ticker symbol was “LRNS”; from August 18, 2005 to December 31, 2005, the Company’s ticker symbol was “LRNSE.” Since February 3, 2006, the Company’s common stock has been traded on the pink sheets under the symbol “LRNS.pk.” The following table sets forth the high and low price per share of the Company’s common stock during fiscal year 2005 and 2004:
On April 10, 2006, there were 9,040,432 outstanding shares of the Company’s common stock held by 127 holders of record.
The Company has not paid and does not presently intend to declare cash dividends. The Company currently intends to retain future earnings to finance its operations and fund the growth of its business. Any payment of future dividends will be at the sole discretion of the Company’s Board of Directors and will depend upon, among other things, the Company’s earnings, results of operations, financial condition, capital requirements, level of indebtedness, contractual restrictions in respect of the payment of dividends, future prospects and other factors deemed relevant to such determination by the Board of Directors. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources.”
The Company has not sold any securities that were not registered under the Securities Act within the past three years. Neither the Company nor any affiliated purchaser purchased any of the Company’s common stock during fiscal year 2005.
Item 6.
Item 6. Selected Financial Data.
SELECTED CONSOLIDATED FINANCIAL DATA
(in thousands, except share and per share data)
The following selected consolidated statements of operations and balance sheet data have been derived from the audited consolidated financial statements of Excelligence Learning Corporation and its predecessor entities. The historical results presented herein are not necessarily indicative of future results and should be read in conjunction with the audited consolidated financial statements and notes thereto beginning on page of this Annual Report on Form 10-K.
(1) On April 30, 2001, the combination of Earlychildhood LLC and SmarterKids.com, Inc. was completed. The financial information reflects the combined results of operations of Excelligence’s predecessor, Earlychildhood, and SmarterKids.com subsequent to May 1, 2001.
(2) Net loss for the year ended December 31, 2001 reflects the pro forma income tax effect of Excelligence and its predecessor companies’ income being subject to federal and state income taxes as a C corporation. The pro forma net loss basic and diluted per share information and shares used in pro forma per share calculation included in the statement of operations data for the year ended December 31, 2001 reflect the impact of the exchange of all of the membership interests in Earlychildhood for shares of Excelligence common stock in the combination as of January 1, 2001 or date of issuance, if later.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Overview
The Company is a developer, manufacturer and retailer of educational products, which are sold to child care programs, preschools, elementary schools and consumers. Through a predecessor entity, the Company began operations in 1985. The Company utilizes multiple sales, marketing and distribution channels, primarily including:
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its Discount School Supply catalog and website, through which the Company develops, markets and sells educational products to early childhood professionals and, to a lesser extent, consumers;
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EPI’s fundraising programs, through which the Company sells school supplies and other products specifically targeted for use by children in kindergarten through sixth grade to elementary schools, teachers and other education organizations;
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its ECMD catalog and website, through which the Company markets and sells furniture and equipment to early childhood professionals; and
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Earlychildhood NEWS, an award winning print and web-based magazine focused on the growth and development of children from infancy through age eight.
All of the foregoing is supported by a national sales force, which, as of December 31, 2005, numbered 59 people.
In fiscal year 2005, the Company operated in two business segments: Early Childhood and Elementary School. The Early Childhood segment includes the brand names Discount School Supply, ECMD and Earlychildhood NEWS . The Early Childhood segment develops, manufactures and sells educational products through multiple distribution channels to early childhood professionals and, to a lesser extent, consumers. The Early Childhood segment also provides information to teachers and other education professionals regarding the development of children from infancy through age eight. The Elementary School segment sells school supplies and other products specifically targeted for use by children in kindergarten through sixth grade to elementary schools, teachers and other education organizations for fundraising activities.
Management’s goal is to continue revenue growth through increasing size of its catalogs, offering new proprietary products, soliciting new customers for its Early Childhood and Elementary School segments, and implementing more aggressive pricing strategies in both segments.
Critical Accounting Policies and Estimates
The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, the Company evaluates its estimates, including those related to revenue recognition, bad debts, product returns, intangible assets, inventories and deferred income taxes. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.
Revenue Recognition and Accounts Receivable
The Company recognizes revenue from product sales upon the delivery of products to an unrelated third party customer when (a) the customer takes title of the goods; (b) the price to the customer is fixed or determinable; (c) the customer is obligated to pay the Company and the obligation is not contingent on resale of the product; (d) the customer’s obligation to the Company would not be changed in the event of theft or physical destruction or damage of the product; and (e) the Company does not have significant obligations for future performance to directly bring about resale of the product by the customer. Provisions for estimated returns and allowances are recorded as a reduction to sales and cost of sales based on historical experience. The Company determines that collectibility of accounts receivable is reasonably assured through standardized credit reviews to determine each customer’s credit worthiness. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
Inventories
The Company uses the lower of cost or market under both the first-in, first-out and average cost methods to value inventories. In the Early Childhood segment, the Company uses the first-in, first-out method for its finished goods inventory and the average cost method for its raw materials inventory related to paint manufacturing. The Elementary School segment uses the average cost method for all inventories. Inventory cost is based on amounts paid to vendors plus the capitalization of certain labor and overhead costs necessary to prepare inventory to be saleable.
The Company writes down its inventory for estimated obsolescence, damaged or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.
While the majority of the Company’s inventory is purchased from domestic vendors, a significant percentage is sourced from overseas. Inventory purchased from foreign vendors constituted 25.8%, 25.7% and 24.5% of the Company’s total inventory purchased for the fiscal years ended December 31, 2005, 2004 and 2003, respectively. The Company takes title to inventory purchased from overseas at point of shipment; the Company takes title to inventory purchased domestically upon receipt for certain vendors, and at point of shipment for certain other vendors.
Impairment of Long-Lived Assets
The Company assesses the need to record impairment losses on long-lived assets used in operations, including goodwill and other intangibles, when indicators of impairment are present. On an on-going basis, management reviews the value and period of amortization or depreciation of its long-lived assets. Recoverability of long-lived assets to be held and used is measured by comparing the carrying value of the asset group to the undiscounted future cash flow expected to be generated by the asset group. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost to sell.
On January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 provides that goodwill should not be amortized but instead be tested for impairment annually at the reporting unit level. In accordance with SFAS No. 142, the Company conducted its annual impairment test as of December 31, 2005. The Company’s goodwill impairment test is based on a comparison of carrying values and fair value of its Company’s reporting units, its Early Childhood and Elementary School segments. As a result of the test, the Company determined that no impairment had occurred. In addition, the Company recorded no impairment charges in 2004 or 2003.
Income Taxes
The Company is taxed as a C corporation and files a consolidated tax return with its wholly-owned subsidiaries. The Company’s consolidated statements of operations reflect the income tax expense based on the actual tax position of the Company and its subsidiaries in effect for the respective periods.
The Company has recorded a deferred tax asset in an amount that is more likely than not to be realized. While the Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the value of the deferred tax asset, in the event that the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should the Company determine that it would not be able to realize all or part of its deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.
Results of Operations
Revenues
Revenues were $132.7 million, $121.0 million and $109.9 million for 2005, 2004 and 2003, respectively. The increase in revenues in 2005 over 2004 of 9.8%, or $11.8 million, was primarily due to growth of 13.2%, or $12.0 million, in the Early Childhood segment. The increase in revenues from 2003 to 2004 of 10.1%, or $11.1 million, was primarily due to growth of 15.8%, or $12.4 million, in the Early Childhood segment. Overall growth in the Early Childhood segment was achieved through new product offerings, which generated $1.7 million in increased revenues, new customer solicitation and improved sales and marketing strategies. Average sales price per unit for the Early Childhood segment increased 5.7% from 2004, with total units sold in the segment up 8.0% from 2004. The Elementary School segment’s revenues decreased by 0.8%, or $228,000, from 2004 to 2005, primarily due to a decrease in total units sold, which was largely offset by increased unit selling prices. The Elementary School segment’s revenues decreased from 2004 to 2005 by 4.3%, or $1.4 million, primarily due to order fulfillment challenges related to the consolidation of warehouses at the beginning of the year.
The Company will continue with its goal to achieve revenue growth in the Early Childhood and Elementary School segments by increasing circulation of its catalogs, offering new proprietary products, soliciting new customers, implementing more aggressive sales and marketing strategies and enhancing the Company’s websites. Certain factors that could cause actual results to differ materially from the Company’s expectations are discussed in “Item 1A. Risk Factors.”
Gross Profit
Gross profit was $46.0 million, $40.6 million and $39.5 million for 2005, 2004 and 2003, respectively. The increase in gross profit in 2005 of $5.4 million was primarily due to an increase in gross profit of 16.6%, or $5.3 million, in the Early Childhood segment. The increase in gross profit in 2004 of $1.1 million was primarily due to an increase in gross profit of 8.4%, or $2.5 million, in the Early Childhood segment. These increases in gross profit within the Early Childhood segment was achieved through more effective sales and marketing strategies.
Gross profit as a percentage of sales was 34.7%, 33.5% and 35.9% for 2005, 2004 and 2003, respectively. Gross profit as a percentage of sales increased from 2004 to 2005 due to improved product sourcing from China, increased sales of proprietary products with higher margins and improved freight management. Gross profit as a percentage of sales decreased from 2003 to 2004 largely due to changes in product sales mix and initiatives to aggressively compete to gain market share in the Early Childhood segment and increased direct labor and freight charges in the Elementary School segment.
The Company accounts for shipping costs as cost of goods sold for shipments made directly from vendors to customers and also for shipments from the Company’s warehouses. The amount of shipping costs related to shipments from the Company’s warehouses for the years ended December 31, 2005, 2004 and 2003 was $8.0 million, $7.6 million and $6.5 million, respectively, or 6.0%, 6.3% and 5.9% as a percentage of sales,
respectively. The improvement in 2005 over 2004 was primarily the result of the Company negotiating improved rate structures with its third party shipping companies. The amount of shipping costs related to shipments made directly from vendors to customers for the years ended December 31, 2005, 2004 and 2003 was $4.6 million, $4.5 million and $3.2 million, respectively, or 3.5%, 3.7% and 2.8% as a percentage of sales, respectively.
Selling, General and Administrative Expenses
Selling, general and administrative expenses include wages and commissions, catalog costs, operating expenses (which include customer service and certain warehouse costs), administrative costs (which include information systems, accounting, legal and human resources), e-business costs, equity-based wages and depreciation of property and equipment. Selling, general and administrative expenses were $39.9 million, $38.3 million and $34.6 million for 2005, 2004, and 2003, respectively. Selling, general and administrative expenses as a percentage of sales were 30.0%, 31.6% and 31.5% for 2005, 2004 and 2003, respectively.
The $1.6 million increase in selling, general and administrative expenses in 2005 over 2004 was wholly attributable to the third and fourth quarters of 2005, during which the Company incurred significant expenses related to an internal investigation and the subsequent restatement of its previously issued financial statements for fiscal year 2004 and the first quarter of 2005. These expenses, consisting of billings from third parties, totaled $2.0 million during these quarters, and included legal and investigative expenses of $1.2 million, audit and review accounting expenses of $578,000, and consultancy expenses of $188,000. The Company has continued to incur these expenses in 2006.
The $3.7 million increase in selling, general and administrative expenses in 2004 over 2003 was attributable to an increase of $3.8 million in the Early Childhood segment, offset by savings of approximately $196,000 in the Elementary School segment. The greatest component of the increase in the Early Childhood segment was legal fees of $874,000 for the Company pursuing a complaint against a competitor for, among other things, trade secret misappropriation, unfair competition and copyright infringement, in addition to costs associated with increasing catalog circulation. The segment also had increases in wages of $506,000 related to increased headcount to strengthen its merchandising and marketing efforts.
The Company does not anticipate significant personnel reductions in 2006. However, the Company will continue to focus on achieving selling, general and administrative operating efficiencies.
Amortization of Other Intangible Assets
Amortization of other intangible assets was $174,000, $173,000 and $279,000 for 2005, 2004, and 2003, respectively. The decrease in amortization for 2004 over 2003 was due to intangible assets acquired in its 1998 acquisition of Colorations, Inc., an Ohio corporation and inactive indirect wholly-owned subsidiary of the Company, becoming fully amortized in 2003.
Interest Expense
Interest expense was $146,000, $89,000, and $261,000 for 2005, 2004 and 2003, respectively, on the Company’s credit facility. The increase in 2005 over 2004 was due to higher interest rates, which more than offset the Company’s lower average borrowings. The decrease in interest expense from 2003 to 2004 was primarily attributable to the Company carrying a lower average outstanding balance on its credit facility with Bank of America, N.A. compared to its previous credit facility with GMAC Business Credit, LLC, which was achieved by the Company’s improved cash management.
Income Taxes
Income tax expense was $2.4 million in 2005 and $793,000 in 2004, whereas income tax benefit was $3.6 million in 2003. In 2005 and 2004, the Company’s effective tax rate was in line with the statutory tax rate, while in 2003, the income tax benefit was lower than the statutory rate due to a reduction of the deferred tax valuation
allowance of $2.8 million. The valuation allowance was related to the deferred income tax assets acquired in the combination of Earlychildhood LLC and SmarterKids.com, Inc. (the “Combination”). During fiscal year 2003, the Company determined that it would be able to realize a larger portion of its deferred tax assets related to net operating losses in excess of the recorded amount and, accordingly, eliminated a portion of its deferred tax asset valuation allowance. During fiscal year 2003, the Company also recognized a current tax benefit of $2.4 million related to net operating losses generated by the Combination. The benefit came from additional net operating losses made available to the Company as a result of a 2003 Internal Revenue Service Notice pertaining to Section 382 limitations.
The Company has recorded a deferred tax asset in an amount that is more likely than not to be realized. In the event the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should the Company determine that it would not be able to realize all or part of its deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.
Recent Accounting Pronouncements
In November 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) should be recognized as current period charges, and that fixed production overheads should be allocated to inventory based on normal capacity of production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS No. 151 did not have a significant impact on the Company’s results of operations or financial position.
In December 2004, FASB issued a revised version of Statements of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation (“SFAS 123R”), which supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS 123R requires recognition of the cost of employee services received in share-based payment transactions, thereby reflecting the economic consequences of those transactions in the financial statements. The accounting provisions of SFAS 123R are effective beginning with the first interim or annual reporting period that begins after September 15, 2005, and the Company will be required to adopt SFAS 123R in the first quarter of 2006. The pro forma disclosures previously permitted under SFAS No. 123 will no longer be an alternative to financial statement recognition. Although it has not yet determined whether the adoption of SFAS 123R will result in amounts that are similar to the current pro forma disclosures under SFAS No. 123, the Company expects the adoption of SFAS 123R will have an adverse impact on the Company’s consolidated statements of operations and net income per share.
In May 2005, FASB issued SFAS No. 154, Accounting Changes and Error Corrections. SFAS No. 154 replaces Accounting Principles Board Opinion No. 20, Accounting Changes in Interim Financial Statements, and is effective for fiscal years beginning after December 15, 2005. SFAS No. 154 requires retrospective application to prior periods’ financial statements of changes in accounting principles, unless it is impracticable to determine either the period-specific effects or the cumulative effects of the changes.
Liquidity and Capital Resources
Effective October 1, 2005, the Company entered into an amendment to its secured credit facility with Bank of America, N.A. (the “Bank of America Facility”), extending the Bank of America Facility for $20.0 million from April 16 to October 15 of each year and $10.0 million from October 16 to April 15 of each year, through its maturity date of October 1, 2007. As of December 31, 2005 and March 31, 2006, the Company had no outstanding borrowings under the Bank of America Facility. Available borrowing capacity as of December 31, 2005 and March 31, 2006 was $10.0 million. The Company’s primary cash needs are for operations and capital
expenditures. Additionally, there may be future cash needs for acquisitions. The Company’s primary source of liquidity is cash flow from operations and the Bank of America Facility. As of December 31, 2005, the Company had net working capital of $30.8 million.
The Bank of America Facility also includes the availability of up to $5.0 million through a reducing revolving term loan. The Bank of America Facility, which is secured by substantially all of the Company’s assets, including receivables, inventory, equipment and intellectual property, requires adherence to certain financial covenants and limitations related to capital expenditures and acquisitions during the term of the Bank of America Facility. As of December 31, 2005, the Company was not in compliance with one of the financial covenants as set forth in the Bank of America Facility.
As of December 31, 2005, the Company was in breach of the covenant set forth in Section 10.2 of the loan agreement for the Bank of America Facility. Section 10.2 of the loan agreement sets certain time limits for the delivery of quarterly financial statements and compliance certificates, which the Company was unable to deliver due to the restatement of the Company’s previously issued financial statements for the fiscal year ended December 31, 2004 and for the quarter ended March 31, 2005, and the resulting delays in finalizing the financial statements for the quarters ended June 30 and September 30, 2005. The Bank waived the Company’s breach of this covenant through February 24, 2006, and the Company was able to regain compliance within the granted extension.
During 2005, the Company’s operating activities provided $8.5 million of cash. The cash provided by net income, increased balances in accounts payable and accrued expenses and decreased balances in accounts receivable and prepaid expenses, which were partially offset by increased balances in inventories. The Company used $1.7 million in cash for investing activities during 2005, with which the Company purchased property and equipment. The Company obtained $360,000 in cash from financing activities as a result of exercised stock options and related tax benefit.
During 2004, the Company’s operating activities provided $581,000 of cash, representing a decrease of $2.2 million from 2003, primarily due to the Company’s decision to enhance market share by offering a bill-when-complete policy that allows customers to receive only one invoice. The Company believes that the policy did improve sales in 2004. The cash provided from operating activities was primarily related to operating income offset by changes to working capital. The Company used $1.9 million in cash for investing activities in 2004, with which the Company purchased property and equipment. The Company realized $320,000 in cash from financing activities as a result of certain employees exercising stock options.
During 2003, the Company’s operating activities provided $2.8 million of cash. The cash provided from operating activities was primarily related to operating income offset by changes to working capital, including inventory liquidations. The Company used $2.1 million in cash for investing activities in 2003, with which the Company acquired Marketing Logistics, Inc. and purchased property and equipment The Company realized $149,000 in cash from financing activities, primarily through issuances of equity.
The following table summarizes the Company’s contractual obligations as of December 31, 2005 and the effect such obligations are expected to have on the Company’s liquidity and cash flow in future periods (in thousands):
Management believes that available cash on hand and availability under the Bank of America Facility will provide adequate funds for the Company’s foreseeable working capital needs and planned capital expenditures. The Company’s ability to fund its operations, repay debt, to make planned capital expenditures and to remain in
compliance with its financial covenants under the Bank of America Facility depends on its future operating performance and cash flow, which in turn, are subject to prevailing economic conditions and to financial, business and other factors, some of which are beyond its control.
As of December 31, 2005, the Company did not have any guarantees, including loan guarantees, standby letters of credit or indirect guarantees.
Off-Balance Sheet Arrangements
There are no off-balance sheet transactions, arrangements or obligations (including contingent obligations) that have, or are reasonably likely to have a material effect on the Company’s financial condition, changes in the financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Seasonality
The Company’s seasonal sales trends coincide with the start of each school year. For the fiscal year ended December 31, 2005, approximately 43% of the Company’s consolidated annual sales were generated in the third calendar quarter. The Company’s working capital needs are greatest during the second calendar quarter as inventory levels are increased to meet seasonal demands. See “Item 1A. Risk Factors-Our business is highly seasonal.”
Inflation
Inflation has and is expected to have only a minor effect on the Company’s results of operations and sources of liquidity.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
The following discussion of market risk includes “forward-looking statements” that involve risks and uncertainties that could significantly offset anticipated results in the future. Actual results could differ materially from those projected in the forward-looking statements. See “Forward-Looking Statements.” The Company does not use derivative financial instruments for speculative or trading purposes.
Interest Rate Risk
The Company’s financial instruments include cash and cash equivalents, accounts receivable, accounts payable and a revolving line of credit. Market risks relating to operations result primarily from a change in interest rates. The Company’s borrowings are primarily dependent upon LIBOR rates. As of December 31, 2005, the Company had no borrowings under the Bank of America Facility and available borrowing capacity of $10.0 million. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources.” The estimated fair value of borrowings under the Bank of America Facility is expected to approximate its carrying value.
Credit Risk
Financial instruments, which potentially subject the Company to concentrations of credit risk, consist primarily of cash, cash equivalents, accounts receivable and its revolving line of credit. The Company has no customer comprising greater than 10% of its revenues. However, receivables arising from the normal course of business are not collateralized and management continually monitors the payment of its accounts receivable and the financial condition of its customers to reduce the risk of loss. The Company does not believe that its cash and cash equivalents are subject to any unusual credit risk beyond the normal credit risk associated with commercial banking relationships.
Foreign Currency Risk
The Company purchases some of its products from foreign vendors. Accordingly, the Company’s prices of imported products are subject to variability based on foreign exchange rates. However, the Company’s purchase orders are denominated in U.S. dollars and the Company does not enter into long-term purchase commitments.
Item 8.
Item 8. Financial Statements and Supplementary Data.
The financial statements listed on the accompanying Index to Consolidated Financial Statements, set forth on page and covered by the Independent Registered Public Accounting Firm’s Report, are incorporated herein by reference and filed as a part of this Annual Report on Form 10-K.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.
During the Company’s two most recent fiscal years or any subsequent interim period, there has been no resignation or dismissal of the independent registered public accounting firm engaged as the principal accountant to audit the Company’s financial statements.
Item 9A.
Item 9A. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
The Company has established and currently maintains disclosure controls and procedures designed to ensure that material information required to be disclosed in its reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission and that any material information relating to the Company is recorded, processed, summarized and reported to its principal officers to allow timely decisions regarding required disclosures. In designing and evaluating the disclosure controls and procedures, management recognizes that controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving desired control objectives. In reaching a reasonable level of assurance, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Due to the matters discussed below and as previously reported, the Company restated its previously issued financial statements for the fiscal year ended December 31, 2004 and for the fiscal quarter ended March 31, 2005. Accordingly, the Company amended its annual report of Form 10-K for the fiscal year ended December 31, 2004 and its quarterly report on Form 10-Q for the fiscal quarter ended March 31, 2005, both of which were filed with the Commission on February 1, 2006.
In conjunction with the close of the period covered by this report, the Company conducted a review and evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer (who is also serving as the Company’s Principal Financial Officer and Principal Accounting Officer), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. As further discussed below, material weaknesses were identified in the Company’s internal control over financial reporting. The Public Company Accounting Oversight Board’s Auditing Standard No. 2 defines a material weakness as a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.
Subsequent to the filing of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004, it came to the attention of management that certain current and former accounting personnel alleged that the Company had improperly failed to record and accrue for certain obligations for the period and fiscal year ended as of that date. In accordance with the Company’s Complaint and Investigation Procedures for Accounting, Internal Accounting Controls, Fraud and Auditing Matters, following a preliminary inquiry by the Company’s General Counsel, the matter was reported to the Audit Committee of the Board of Directors. The Audit Committee engaged independent counsel to conduct an investigation and to direct forensic accounting
consultants to assist in the investigation. The results of that investigation were reported to the Audit Committee and the Board of Directors, and included findings which, upon the recommendation of management, the Board determined would require a material adjustment to, and restatement of, the previously reported financial statements for the year ended December 31, 2004 and for the quarter ended March 31, 2005. These restatements were filed with the Commission on February 1, 2006.
The Company determined that this restatement is attributable to a number of factors. The most significant factor was the Company’s failure to timely record and to accrue for certain invoices relating to inventory on hand as of year end. The Company determined, based upon the results of its internal investigation, that its accrual of accounts payable for inventory did not include certain inventory items that had been received but had not been paid for by the Company prior to the end of fiscal 2004. As a result of the in-depth review procedures performed by the Company, the forensic accountants and its registered independent public accountants, certain additional accounting errors were identified relating to 2004 which are also reflected in the restatement. Those additional errors included understatement of costs capitalized to inventory, an understatement of the provision for sales returns, an understatement of certain selling, general and administrative expenses, an understatement of compensation expense for deferred compensation amounts relating to previously issued stock options, and an understatement of income taxes related to stock option exercises.
The restatement of previously issued financial statements is a strong indicator that one or more material weaknesses in controls over financial reporting may exist. As a result, the Company’s Chief Executive Officer and Board of Directors have concluded that, as of December 31, 2005, the end of the period covered by this annual report, the Company’s disclosure controls and procedures were not effective to ensure that information required to be disclosed under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.
The material weaknesses that were found to exist are:
·
Inadequate staffing and training in the accounting function over the Company’s processing of certain financial information.
Management identified this material weakness based on the internal investigation conducted at the direction of the Audit Committee, including review of the work product of the forensic accountants retained to assist in the investigation. The Company believes that invoices relating to inventory on hand at year end were not timely processed for payment and were not adequately accrued. The internal investigation revealed that the Company set aside certain invoices pending completion of the year end audit without determining whether the invoices were properly accrued and that some of the Company’s accounting personnel were aware of this treatment of invoices, but failed to bring the matter to the attention of appropriate senior management, the Audit Committee, or the independent auditors. The Company has determined that this material weakness contributed to the failure to timely record and to properly accrue for certain invoices (relating primarily to inventory and catalog costs) as of December 31, 2004. These conditions also contributed to the other errors that were noted and corrected during the in-depth review procedures performed by the Company, the forensic accountants and the Company’s independent registered public accounting firm.
·
Improper segregation of duties over the processing and review of journal entries.
Management identified this material weakness based on an incorrect journal entry directed by the former Chief Financial Officer, which was found during the course of the investigation and reduced the accounts payable expense for inventory on hand at year end. The investigation revealed and management confirmed that the adjusting journal entry was not adequately justified and was out of line with the Company’s ordinary practices. Although the investigation revealed that other accounting employees, including the former Controller, were aware of and disagreed with the adjusting entry, they did not raise the matter with other senior management, the Audit Committee, or the Company’s independent registered public accounting firm.
Evaluation of Disclosure Controls and Procedures
Certain changes in the Company’s internal control over financial reporting during the fiscal year ended December 31, 2005 that materially affected, or were reasonably likely to affect, the Company’s control over financial reporting are described below.
Subsequent to the discovery of the material weaknesses, the Company has taken and continues to take the following steps to remediate the material weaknesses found to exist during its evaluation of disclosure controls and procedures:
·
The first identified material weakness had already begun being remediated by the Company with its implementation of procedures in May 2005 to ensure that its accounts payable invoices are processed promptly in accordance with standard procedures when received, and that accruals are maintained and reviewed by appropriate senior accounting and financial reporting management on a monthly basis. In addition, the Company’s Chief Financial Officer resigned effective as of September 13, 2005 and the Company is in the process of identifying a new Chief Financial Officer. The Company’s former Controller had been terminated in June 2005. The Company has significantly increased the number and skills and training of management and staff personnel in its accounting and finance departments, including training in the Company’s whistleblower policies and procedures, implemented enhanced segregation of duties, and documented and implemented specific desk-level procedures in the accounting and financial reporting departments. Additional safeguards and controls are being evaluated. The Company believes the steps it has taken, and intends to take, will substantially remediate this material weakness.
·
To remediate the second identified material weakness, the Company has implemented and documented rigorous and detailed procedures for the closing of each fiscal period that include specific protocols for the timely review by appropriate senior accounting and financial reporting management of all adjusting journal entries. In addition, the Company significantly increased the number and skills and training of management and staff personnel in its accounting and finance departments, including training in the Company’s whistleblower policies and procedures, and implemented enhanced segregation of duties. In addition, as noted, the Company is in the process of identifying a new Chief Financial Officer and has replaced the former Controller. Additional controls and safeguards are being evaluated. The Company believes that the steps it has taken, and intends to take, will substantially remediate this material weakness.
In addition to the remediation steps describe above, the Company has:
·
Implemented new software enhancements to improve and/or integrate major systems and enhance the control environment in the areas of financial planning and analysis, internal reporting, and integration of the sales order entry and inventory subsystems with the general ledger system;
·
Initiated training and education of all relevant personnel involved in interactions with the Company’s independent registered public accounting firm designed to ensure that such personnel understand and comply with the provisions of the Securities Exchange Act of 1934, and the rules promulgated thereunder, regarding representations to the Company’s independent registered public accountants;
·
Communicated with all Company employees reaffirming the Company’s whistleblower protections; and
·
Accelerated the documentation and internal control evaluation processes contemplated by Section 404 of the Sarbanes-Oxley Act.
Management believes the measures that have been and will be implemented to remediate the material weaknesses have had a significant and positive impact on the Company’s internal control over financial reporting since December 31, 2004 and anticipates that these measures and other ongoing enhancements will continue to strengthen the Company’s internal control over financial reporting in future periods.
Although the Company has implemented and continues to implement remediation efforts, a material weakness indicates that there is more than a remote likelihood that a material misstatement of the Company’s financial statements will not be prevented or detected. In addition, the Company cannot ensure that it will not in the future identify further material weaknesses or significant deficiencies in its internal control over financial reporting that it has not discovered to date. The Company has taken and is taking steps to improve its internal control over financial reporting. The efforts it has taken and continues to take are subject to continued management review supported by confirmation and testing by management, as well as Audit Committee oversight. As a result, additional changes are expected to be made to the Company’s internal control over financial reporting. Other than the foregoing initiatives since the date of the evaluation supervised by management, there have been no material changes in the Company’s disclosure controls and procedures, or the Company’s internal control over financial reporting, that could have materially affected, or are reasonably likely to materially affect, the Company’s disclosure controls and procedures or the Company’s internal control over financial reporting.
The Company performed additional analyses and other post-closing procedures to address the material weaknesses and to ensure that the consolidated financial statements contained in this report were prepared in accordance with generally accepted accounting principles. Accordingly, management believes that the financial statements included in this report fairly present in all material respects the Company’s financial position, results of operations and cash flows for the periods presented.
Item 9B.
Item 9B. Other Information.
None.
PART III.
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
The information required by this item will be set forth under “Directors and Executive Officers” and “Compliance with Section 16(a) Under the Securities Exchange Act of 1934” in the Company’s definitive proxy statement to be filed with the Commission in connection with the Company’s 2006 annual meeting of stockholders, and reference is expressly made thereto for the specific information incorporated by reference herein.
The Company has adopted a Code of Business Conduct and Ethics that applies to the Company’s directors, officers (including the Chief Executive Officer, Chief Financial Officer, Controller and persons performing similar functions), employees, agents and consultants. This Code satisfies the requirements of a “code of business conduct and ethics” under the Nasdaq Rules and a “code of ethics” within the meaning of Section 406 of the Sarbanes-Oxley Act of 2002 and applicable SEC rules. This Code of Business Conduct and Ethics has been posted to the Company’s website at www.excelligencelearning.com under Company Policies. Amendments to, or waivers from, a provision of this Code of Business Conduct and Ethics that apply to the Company’s directors or executive officers, including the Chief Executive Officer, Chief Financial Officer, Controller and persons performing similar functions, may be made only by the Board and will be promptly posted on the Company’s website.
Item 11.
Item 11. Executive Compensation.
The information required by this item will be set forth under “Executive Compensation” in the Company’s definitive proxy statement to be filed with the Commission in connection with the Company’s 2006 annual meeting of stockholders, and reference is expressly made thereto for the specific information incorporated by reference herein.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by this item will be set forth under “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” in the Company’s definitive proxy statement to be filed with the Commission in connection with the Company’s 2006 annual meeting of stockholders, and reference is expressly made thereto for the specific information incorporated by reference herein.
Item 13.
Item 13. Certain Relationships and Related Transactions.
The information required by this item will be set forth under “Certain Relationships and Related Transactions” in the Company’s definitive proxy statement to be filed with the Commission in connection with the Company’s 2006 annual meeting of stockholders, and reference is expressly made thereto for the specific information incorporated by reference herein.
Item 14.
Item 14. Principal Accountant Fees and Services.
The information required by this item will be set forth under “Audit Committee Report-Fees” in the Company’s definitive proxy statement to be filed with the Commission in connection with the Company’s 2006 annual meeting of stockholders, and reference is expressly made thereto for the specific information incorporated by reference herein.
PART IV.
Item 15.
Item 15. Exhibits and Financial Statement Schedules.
(a) Financial Statements
(1) The financial statements listed on the accompanying Index to Consolidated Financial Statements, set forth on page and covered by the Independent Registered Public Accounting Firm’s Report, are incorporated herein by reference and filed as a part of this Annual Report on Form 10-K.
(2) The financial schedule appearing on page and covered by the Independent Registered Public Accounting Firm’s Report is incorporated herein by reference and filed as part of this Annual Report on Form 10-K.
(3) Exhibits.
* Filed herewith.
+ Management contracts or compensatory plans or arrangements required to be filed as Exhibits by Item 601(b)(10)(iii) of Regulation S-K.
(1) Incorporated by reference from Annex A to the Proxy-Statement Prospectus contained in Part I of Post-Effective Amendment No. 2 to the Registrant’s Registration Statement on Form S-4 filed with the Commission on April 27, 2001 (File No. 333-53454).
(2) Incorporated by reference from Annex A-1 to the Proxy-Statement Prospectus contained in Part I of Post-Effective Amendment No. 2 to the Registrant’s Registration Statement on Form S-4 filed with the Commission on April 27, 2001 (File No. 333-53454).
(3) Incorporated by reference from Amendment No. 1 to the Registrant’s Registration Statement on Form S-4 filed with the Commission on February 21, 2001 (File No. 333-53454).
(4) Incorporated by reference from Amendment No. 2 to the Registrant’s Registration Statement on Form S-4 filed with the Commission on March 7, 2001 (File No. 333-53454).
(5) Incorporated by reference from the Registrant’s Registration Statement on Form S-8 filed with the Commission on July 9, 2001 (File No. 333-64762).
(6) Incorporated by reference from the Registrant’s Registration Statement on Form S-8 filed with the Commission on July 9, 2001 (File No. 333-64764).
(7) Incorporated by reference from the Registrant’s Quarterly Report on Form 10-Q/A for the Quarter Ended June 30, 2001, filed with the Commission on August 15, 2001 (File No. 000-32613).
(8) Incorporated by reference from the Registrant’s Registration Statement on Form S-8 filed with the Commission on December 20, 2001 (File No. 333-75602).
(9) Incorporated by reference from the Registrant’s Annual Report on Form 10-K for the Year Ended December 31, 2001, filed with the Commission on March 29, 2002 (File No. 000-32613).
(10) Incorporated by reference from the Registrant’s Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2002, filed with the Commission on August 14, 2002 (File No. 000-32613).
(11) Incorporated by reference from the Registrant’s Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2003, filed with the Commission on August 7, 2003 (File No. 000-32613).
(12) Incorporated by reference from the Registrant’s Current Report on Form 8-K, filed with the Commission on September 29, 2003 (File No. 000-32613).
(13) Incorporated by reference from the Registrant’s Quarterly Report on Form 10-Q for the Quarter Ended September 30, 2003, filed with the Commission on November 7, 2003 (File No. 000-32613).
(14) Incorporated by reference from the Registrant’s Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2003, filed with the Commission on March 11, 2004 (File No. 000-32613).
(15) Incorporated by reference from the Registrant’s Quarterly Report on Form 10-Q for the Quarter Ended March 31, 2004, filed with the Commission on May 11, 2004 (File No. 000-32613).
(16) Incorporated by reference from the Registrant’s Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2004, filed with the Commission on August 13, 2004 (File No. 000-32613).
(17) Incorporated by reference from the Registrant’s Current Report on Form 8-K, filed with the Commission on October 5, 2005. (File No. 000-32613).
(18) Incorporated by reference from the Registrant’s Current Report on Form 8-K, filed with the Commission on December 20, 2005. (File No. 000-32613).
(19) Incorporated by reference from the Registrant’s Quarterly Report on Form 10-Q for the Quarter Ended September 30, 2005, filed with the Commission on February 15, 2006 (File No. 000-32613).
(20) Incorporated by reference from the Registrant’s Current Report on Form 8-K, filed with the Commission on December 19, 2005. (File No. 000-32613).
(21) Incorporated by reference from the Registrant’s Current Report on Form 8-K, filed with the Commission on May 26, 2005. (File No. 000-32613).
(b) The exhibits required by Item 601 of Regulation S-K are listed above.
(c) Financial Statement Schedules.
The financial schedule appearing on page and covered by the Independent Registered Public Accounting Firm’s Report is incorporated herein by reference and filed as part of this Annual Report on Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
EXCELLIGENCE LEARNING CORPORATION
By:
/s/ RONALD ELLIOTT
Ronald Elliott
Chief Executive Officer
Dated: April 14, 2006
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
The following consolidated financial statements are filed as part of this Annual Report on Form 10-K:
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Excelligence Learning Corporation:
We have audited the consolidated financial statements of Excelligence Learning Corporation and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule on valuation and qualifying accounts as listed in the accompanying index. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Excelligence Learning Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth herein.
/s/ KPMG LLP
San Francisco, California
April 7, 2006
EXCELLIGENCE LEARNING CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except for par value and share amounts)
See accompanying notes to consolidated financial statements.
EXCELLIGENCE LEARNING CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except for share and per share amounts)
See accompanying notes to consolidated financial statements.
EXCELLIGENCE LEARNING CORPORATION
CONSOLIDATED STATEMENTS OF EQUITY
(In thousands, except for share amounts)
See accompanying notes to consolidated financial statements.
EXCELLIGENCE LEARNING CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
See accompanying notes to consolidated financial statements.
EXCELLIGENCE LEARNING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) The Business
Excelligence Learning Corporation, a Delaware corporation (the “Company”), is a developer, manufacturer and retailer of educational products, which are sold to child care programs, preschools, elementary schools and consumers. The Company was incorporated in the State of Delaware on November 6, 2000 for the purpose of effecting the combination (the “Combination”) of the businesses of Earlychildhood LLC, a California limited liability company (“Earlychildhood”), and SmarterKids.com, Inc., a Delaware corporation. The Company’s business is primarily conducted through its wholly-owned subsidiaries, Earlychildhood, Educational Products, Inc., a Texas corporation (“EPI”), and Marketing Logistics, Inc., a Minnesota corporation dba Early Childhood Manufacturers’ Direct (“ECMD”).
(2) Summary of Significant Accounting Policies
Critical Accounting Policies and Estimates
(a) Revenue Recognition and Accounts Receivable
The Company recognizes revenue from product sales upon the delivery of products to an unrelated third party customer when (a) the customer takes title of the goods; (b) the price to the customer is fixed or determinable; (c) the customer is obligated to pay the Company and the obligation is not contingent on resale of the product; (d) the customer’s obligation to the Company would not be changed in the event of theft or physical destruction or damage of the product; and (e) the Company does not have significant obligations for future performance to directly bring about resale of the product by the customer. Provisions for estimated returns and allowances are recorded as a reduction to sales and cost of sales based on historical experience. The Company determines that collectibility of accounts receivable is reasonably assured through standardized credit review to determine each customer’s credit worthiness. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
(b) Inventories
The Company uses the lower of cost or market under both the first-in, first-out and average cost methods to value inventories. In the Early Childhood segment, the Company uses the first-in, first-out method for its finished goods inventory and the average cost method for its raw materials inventory related to paint manufacturing. The Elementary School segment uses the average cost method for all inventories. Inventory cost is based on amounts paid to vendors plus the capitalization of certain labor and overhead costs necessary to prepare inventory to be saleable.
The Company writes down its inventory for estimated obsolescence, damaged or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.
(c) Accounting for Impairment of Long-Lived Assets
The Company assesses the need to record impairment losses on long-lived assets used in operations, including goodwill and other intangibles, when indicators of impairment are present. On an on-going basis, management reviews the value and period of amortization or depreciation of its long-lived assets. Recoverability of long-lived assets to be held and used is measured by comparing the carrying value of the asset group to the
undiscounted future cash flow expected to be generated by the asset group. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds fair value. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost to sell.
On January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets . SFAS No. 142 provides that goodwill should not be amortized but instead be tested for impairment annually at the reporting unit level. In accordance with SFAS No. 142, the Company conducted its annual impairment test as of December 31, 2005. The Company’s goodwill impairment test is based on a comparison of carrying values and fair value of its Company’s reporting units, its Early Childhood and Elementary School segments. As a result of the test, the Company determined that no impairment had occurred. In addition, the Company recorded no impairment charges in 2004 or 2003.
(d) Income Taxes
The Company is taxed as a C corporation and files a consolidated tax return with its wholly-owned subsidiaries. The Company’s consolidated statements of operations reflect the income tax expense based on the actual tax position of the Company and its subsidiaries in effect for the respective periods.
The Company has recorded a deferred tax asset in an amount that is more likely than not to be realized. While the Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the value of the deferred tax asset, in the event that the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should the Company determine that it would not be able to realize all or part of its deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.
(e) Use of Estimates in Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted accounting principles requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, the Company evaluates its estimates, including those related to revenue recognition, bad debts, product returns, intangible assets, inventories and deferred income taxes. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Other Accounting Policies
(a) Principles of Consolidation
The consolidated financial statements include the accounts of the Company and wholly-owned subsidiaries. All material intercompany transactions have been eliminated in consolidation.
(b) Fiscal Year
The Company’s fiscal year end is December 31.
(c) Cash Equivalents
The Company considers all highly liquid investments with a remaining maturity of three months or less at the date of the acquisition to be cash equivalents. As of December 31, 2005 and 2004, cash equivalents consisted of various deposit accounts and an overnight investment account totaling $9.9 million and $2.7 million, respectively. The increased balance in 2005 resulted from increased cash provided by operations.
(d) Concentration of Credit Risk
The Company has no customer comprising greater than 10% of its revenues. However, receivables arising from sales to customers are not collateralized and management continually monitors the financial condition of its customers to reduce the risk of loss.
(e) Deferred Catalog Costs
Deferred catalog costs are considered direct response advertising and are capitalized and amortized in amounts proportionate to revenues over the lives of each catalog, generally five months. Such costs are included in prepaid expenses and other current assets. Amortization expense related to deferred catalog costs is included in the statements of operations as a component of selling, general and administrative expenses. Such amortization expense was $4.7 million, $4.7 million and $3.3 million for the years ended December 31, 2005, 2004 and 2003, respectively.
(f) Property and Equipment
Property and equipment are stated at cost less accumulated depreciation. Leasehold improvements are capitalized and amortized over the lesser of the remaining life of the asset or the remaining term of the lease. Maintenance and repairs are expensed as incurred. Depreciation expense for property and equipment is calculated using the straight-line method over the estimated useful lives of the respective assets. The estimated useful lives range from five to 10 years for leasehold improvements and three to seven years for furniture, fixtures, equipment, computer and software.
Depreciation of property and equipment amounted to $1.7 million, $1.5 million and $1.4 million for the years ended December 31, 2005, 2004 and 2003, respectively.
(g) Intangible Assets
Trademarks and definite live intangible assets are stated at cost, and are being amortized on the straight-line basis over their estimated useful lives, which range from five to ten years.
(h) Shipping and Handling
Shipping and handling revenues are included in revenue. Shipping costs are included in cost of goods sold. Costs directly associated with warehouse operations of $7.2 million, $7.1 million, and $7.0 million for the years ended December 31, 2005, 2004 and 2003, respectively, were included in selling, general and administrative expenses.
(i) Equity-Based Compensation
The Company accounts for its equity-based compensation plans in accordance with SFAS No. 123, Accounting for Stock-Based Compensation. As permitted by SFAS No. 123, the Company measures compensation cost in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees , and related interpretations. As a result, no accounting recognition is given at the date of grant to stock options granted to employees with an exercise price equal to the fair market value of the underlying common stock. Upon exercise, net proceeds, including income tax benefits realized, are credited to equity. Compensation cost for stock options granted with exercise prices below the fair market value of the underlying common stock is recognized over the vesting period. The pro forma impact on earnings has been disclosed in the notes to the financial statements as allowed by SFAS No. 123.
The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, to stock-based employee compensation:
The weighted average fair value per share of options granted during 2005, 2004 and 2003 was $4.57, $3.40 and $5.58, respectively. The fair value of these options was estimated using the Black-Scholes model with the following weighted average assumptions:
(j) Comprehensive Income
SFAS No. 130, Reporting Comprehensive Income, requires that the Company report comprehensive income, which includes net income as well as other changes in assets and liabilities recorded directly to equity, in its financial statements. There were no components of comprehensive income other than net income for all periods presented.
(k) Basic and Diluted Net Income per Share
In accordance with SFAS No. 128, Earnings Per Share, basic net income per share is computed by dividing net income by the weighted daily average number of shares of common stock outstanding during the period. Diluted net income per share is based upon the weighted daily average number of shares of common stock outstanding for the period plus potentially dilutive common shares, including stock options using the treasury-stock method.
The following table sets forth the computation of basic and diluted net income per share (in thousands, except share and per share amounts):
The following potential shares of common stock have been excluded from the computation of diluted net income per share because the effect of including these shares would have been anti-dilutive:
The weighted-average exercise price of options to purchase common stock excluded from the computation of diluted net income per share was $8.13, $6.16 and $8.62 for the years ended December 31, 2005, 2004 and 2003, respectively.
(l) Fair Value of Financial Instruments
The carrying value for cash and cash equivalents, accounts receivable, short-term debt, accounts payable and notes payable approximates fair value because of the short term nature of these instruments.
(m) Recent Accounting Pronouncements
In November 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) should be recognized as current period charges, and that fixed production overheads should be allocated to inventory based on normal capacity of production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS No. 151 did not have a significant impact on the Company’s results of operations or financial position.
In December 2004, FASB issued a revised version of Statements of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation (“SFAS 123R”), which supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS 123R requires recognition of the cost of employee services received in share-based payment transactions, thereby reflecting the economic consequences of those transactions in the financial statements. The accounting provisions of SFAS 123R are effective beginning with the first interim or annual reporting period that begins after September 15, 2005, and the Company will be required to adopt SFAS 123R in the first quarter of 2006. The pro forma disclosures previously permitted under SFAS No. 123 will no longer be an alternative to financial statement recognition. See “Equity-Based Compensation” above for the pro forma net income and net income per share amounts for the fiscal years ended December 31, 2005, 2004 and 2003 as if the Company had used a fair-value-based method similar to the methods required under SFAS 123R to measure compensation expense for employee
stock incentive awards. Although it has not yet determined whether the adoption of SFAS 123R will result in amounts that are similar to the current pro forma disclosures under SFAS No. 123, the Company expects the adoption of SFAS 123R will have an adverse impact on the Company’s consolidated statements of operations and net income per share.
In May 2005, FASB issued SFAS No. 154, Accounting Changes and Error Corrections. SFAS No. 154 replaces Accounting Principles Board Opinion No. 20, Accounting Changes in Interim Financial Statements, and is effective for fiscal years beginning after December 15, 2005. SFAS No. 154 requires retrospective application to prior periods’ financial statements of changes in accounting principles, unless it is impracticable to determine either the period-specific effects or the cumulative effects of the changes.
(n) Reclassifications
Certain prior year balances have been reclassified to conform to the current year presentation.
(3) Redeemable Common Shares
On February 19, 2003, the Company consummated its acquisition of Marketing Logistics, Inc., an online retailer of early childhood furniture and equipment now doing business as ECMD. Consideration for the acquisition included $800,000 in cash and 100,000 redeemable shares of the Company’s common stock. The seller had a one-time opportunity, exercisable during the thirty-day period prior to February 19, 2004, to exchange the shares received by him in the acquisition for $400,000 in cash. The exercise period has expired and the shares were not redeemed; therefore, the redeemable common shares were reclassified to equity in 2004.
(4) Accounts Receivable
Accounts receivable consisted of the following amounts (in thousands):
(5) Inventories
Inventories, stated at lower of cost or market, consisted of the following amounts (in thousands):
(6) Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consisted of the following amounts (in thousands):
(7) Property and Equipment
A summary of property and equipment is as follows (in thousands):
(8) Other Intangible Assets
As of December 31, 2005 and 2004, the major classes of intangible assets were as follows (in thousands):
Total amortization expense on intangible assets for the years ended December 31, 2005, 2004 and 2003 was $174,000, $173,000 and $279,000, respectively. The carrying amount of goodwill was $5.9 million at December 31, 2005 and 2004.
Estimated amortization expense (in thousands) for the years ended December 31,
The following table identifies the weighted average remaining life of the Company’s intangible assets (dollars in thousands):
(10) Accrued Expenses
Accrued expenses consisted of the following amounts (in thousands):
(11) Credit Facility
Effective October 1, 2005, the Company entered into an amendment extending the Bank of America Facility for $20.0 million from April 16 to October 15 of each year and $10.0 million from October 16 to April 15 of each year until its maturity date of October 1, 2007. As of December 31, 2005 and March 31, 2006, the Company had no outstanding borrowings under the Bank of America Facility. Available borrowing capacity as of December 31, 2005 and March 31, 2006 was $10.0 million.
The Bank of America Facility also includes the availability of up to $5.0 million through a reducing revolving term loan. The Bank of America Facility, which is secured by substantially all of the Company’s assets, including receivables, inventory, equipment and intellectual property, requires adherence to certain financial covenants and limitations related to capital expenditures and acquisitions during the term of the Bank of America Facility. As of December 31, 2005, the Company was not in compliance with one of the financial covenants as set forth in the Bank of America Facility.
As of December 31, 2005, the Company was in breach of the covenant set forth in Section 10.2 of the loan agreement for the Bank of America Facility. Section 10.2 of the loan agreement sets certain time limits for the delivery of quarterly financial statements and compliance certificates, which the Company was unable to deliver due to the restatement of the Company’s previously issued financial statements for the fiscal year ended December 31, 2004 and for the quarter ended March 31, 2005, and the resulting delays in finalizing the financial statements for the quarters ended June 30 and September 30, 2005 . The Bank waived the Company’s breach of this covenant through February 24, 2006, and the Company was able to regain compliance within the granted extension.
(12) Related Party Transactions
During the first seven months of 2005, the Company leased its Salinas paint manufacturing facility center from an entity owned by its Chief Executive Officer and another significant stockholder. The lease expired on August 5, 2005 and included monthly rent payments of $24,885. During 2005, the facility was sold to an unrelated third party, from whom the facility continues to be leased by the Company. During the fiscal years ended December 31, 2005 and 2004, the Company paid the landlord entity $96,965 and $289,922, respectively.
The Company purchases product for sale from an entity of which one of its directors is the Managing Director and majority shareholder. During the fiscal years ended December 31, 2005 and 2004, the Company paid the entity $154,988 and $66,985, respectively.
(13) Income Taxes
The Company’s consolidated statements of operations reflect the income tax expense (benefit) based on the actual tax position of the company and its subsidiaries in effect for the respective periods. The following table reflects the components of the provision for income taxes of the Company and its subsidiaries for the respective periods (in thousands):
The Company’s actual tax expense (benefit) differed from the statutory federal income tax rate of 35% for the years ended December 31, 2005, 2004 and 2003, as shown in the following schedule (in thousands):
The following table displays the tax effects of temporary differences (in thousands):
The valuation allowance is mainly related to the deferred income tax assets acquired in the Combination. The Company has recorded a deferred tax asset in an amount that is more likely than not to be realized. A valuation allowance has been established for the net operating loss, which, if not utilized, will expire between 2006 and 2020. The Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. In the event that the Company were to determine that it would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. Although the valuation allowance was related to the assets acquired in the Combination, the 2003 and 2004 reduction in the beginning period valuation allowance has been reflected as a reduction to income tax expense because the long-lived assets acquired in the Combination were impaired and written off in the year ended December 31, 2001. The reduction in the year ended December 31, 2005 was the result of the expiration of State of Massachusetts net operating losses for which the Company had previously provided a valuation allowance.
As of December 31, 2005, the Company had federal and state net operating loss carry forwards of approximately $15.0 million and $11.2 million, respectively. If not utilized, these net operating loss carry forwards will expire in years 2006 through 2021. The Company’s ability to utilize certain loss carry forwards is subject to limitations pursuant to the ownership change rules of Internal Revenue Code Section 382.
During fiscal year 2003, the Company recognized a current tax benefit of $2.4 million related to net operating losses generated by the SmarterKids.com acquisition. The benefit came from additional net operating losses made available to the Company as a result of a 2003 Internal Revenue Service Notice pertaining to Section 382 limitations. Also, during fiscal year 2003, the Company determined that it would be able to realize a larger portion of its deferred tax assets related to net operating losses in excess of the recorded amount and, accordingly, eliminated a portion of its deferred tax asset valuation allowance. This resulted in a tax benefit of $2.8 million for fiscal year 2003.
(14) Employee Benefits
Retirement Savings Plan
Employees of the Company are eligible to participate in the Excelligence Learning Corporation 401(k) Plan (the “Plan”). The Plan is a defined contribution plan operating under Section 401(k) of the Internal Revenue Code of 1986, as amended. Employees are eligible to participate in the Plan after completing 90 days of service. Participants may defer up to 15% of their compensation, up to a maximum of 14,000 in 2005, as a contribution to the Plan. Participants who are 50 years or older had the option to defer an additional $4,000 in 2005. The Company matches 15% of employee contributions to the Plan up to a maximum of 6% of their compensation.
Participant contributions are 100% vested immediately. Employer contributions are subject to the following vesting schedule:
The Company’s expense related to matching participants’ contributions to the Plan was $74,000, $44,000, and $60,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
Stock Options
In March 2001, the Company adopted its 2001 Stock Option and Incentive Plan, pursuant to which the Company’s Board of Directors may grant stock options to key employees, directors and certain consultants of the Company. The 2001 Stock Option and Incentive Plan, which was amended and restated in its entirety in May 2003 upon receipt of stockholder approval, authorizes grants of options to purchase up to 1.8 million shares of common stock. Grants under the Stock Option and Incentive Plan are made at a price equal to fair market value of the Common Stock on the date of grant and, in general, vest in equal portions over a term of three years from the grant date.
In March 2001, the Company also adopted its 2001 Non-Employee Director Stock Option Plan, pursuant to which the Company’s Board of Directors may grant stock options as an inducement to obtain and retain the services of qualified persons who are not employees or officers of the Company to serve as members of its Board of Directors. The 2001 Non-Employee Director Stock Option Plan authorizes grants of options to purchase up to 300,000 shares of common stock. Grants under the Non-Employee Director Stock Option Plan are made at a price equal to fair market value of the Common Stock on the date of grant and vest in equal portions over a term of three years from the date the recipient is elected as a non-employee director.
The following table summarizes stock option activity for the three years ended December 31, 2005:
The following table summarizes significant ranges of outstanding and exercisable options at December 31, 2005:
In March 2001, the Company adopted the Excelligence Learning Corporation 2001 Employee Stock Purchase Plan that covers substantially all employees, which was amended and restated in its entirety for the second time in May 2002 upon receipt of stockholder approval. By contributing a percentage of their compensation, participants in the plan may elect to purchase the Company’s common stock at a 15% discount of the lower of the closing price at the beginning or end of any six-month payment period. The first six-month payment period began in March 2002. The Company suspended the 2001 Employee Stock Purchase Plan in August 2003. The number of shares purchased through the plan for fiscal year 2003 was 21,652, with an average price of $1.91.
Recorded Deferred Compensation
On April 30, 2001, Earlychildhood and SmarterKids.com combined pursuant to a Contribution Agreement and Plan of Reorganization and Merger (as amended, the “Combination Agreement”). The Combination Agreement provided for (i) the holders of all of Earlychildhood’s outstanding membership interests to contribute their entire ownership interest in Earlychildhood in exchange for Excelligence common stock and (ii) S-E Educational Merger Corp., a wholly-owned subsidiary of Excelligence, to be merged with and into SmarterKids.com and the outstanding shares of SmarterKids.com to be converted into shares of common stock of Excelligence. In addition, the Combination Agreement provided for holders of options to purchase Earlychildhood membership interests to have their options exchanged for options to purchase Excelligence common stock, holders of options to purchase SmarterKids.com common stock to have their options converted into options to purchase Excelligence common stock and holders of warrants to purchase SmarterKids.com common stock to have their warrants cancelled.
Earlychildhood had recorded deferred compensation of $2.8 million in the year ended December 31, 2000, representing the difference between the exercise price of the outstanding options to purchase membership interests in Earlychildhood and the implied fair value of the related Earlychildhood membership interests at the date of grant. The implied fair value was calculated based upon the assumed exchange for shares of the Company in conjunction with the proposed Combination. Such implied fair value was based upon the fair market value of SmarterKids.com at the announcement date of the proposed Combination. The deferred compensation reflected in membership interests was amortized over five years, representing the period over which the repurchase provisions ratably lapse. The remainder of the deferred compensation amount was recorded by the Company in the year ended December 31, 2005.
Options issued under Earlychildhood’s 2000 Management Equity Incentive Option Plan were to become exercisable at a rate of 33.3% per year on the anniversary date of grant and were to expire ten years from the date of grant. The membership interests which were to be acquired by virtue of exercise of the options were subject to repurchase by the Company at cost in the event of employee termination for any reason other than for cause. Such repurchase provisions were to lapse at an annual rate of 20.0% each year, measured from the grant date.
(15) Lease Commitments
The Company leases its facilities and certain equipment under non-cancelable lease agreements, which expire at various dates. Future minimum lease payments as of December 31, 2005 under operating leases are as follows (in thousands):
As provided in SFAS No. 13, Accounting for Leases, rental expenses for certain operating lease agreements with step rent increases and other lease incentives are recognized on a straight-line basis over the term of the lease. Total rental expense under operating leases was $3.9 million, $3.7 million and $3.9 million for December 31, 2005, 2004, and 2003, respectively.
As stated in Note 12, the Company previously leased one of its warehouse facilities from a company owned by its Chief Executive Officer and one of its other significant stockholders.
(16) Legal Matters
The staff in the Division of Enforcement in the San Francisco District Office of the Commission informed the Company in October 2005 that it was conducting an informal inquiry into the Company’s restatement and the related circumstances. At that time, the staff requested that the Company preserve certain documents related to this inquiry and provide on a voluntary basis certain documents to the staff for its review. The Company has cooperated with the informal inquiry and provided documents and information in response to the staff’s requests. The staff obtained a non-public formal order of investigation from the Commission in January 2006. The Company intends to continue to cooperate with the staff and Commission in connection with the formal investigation.
Aside from the above-referenced administrative proceeding, the Company and its subsidiaries are, from time to time, party to legal proceedings arising in the normal course of business. In management’s opinion, there are no pending claims or litigation, the outcome of which would have a material effect on the Company’s consolidated results of operations, financial position or cash flows.
(17) Segment Information
The Company operates in two business segments, the Early Childhood segment and the Elementary School segment. The Early Childhood segment includes the brand names Discount School Supply, ECMD and Earlychildhood NEWS. The Early Childhood segment develops, manufactures and sells educational products through multiple distribution channels to early childhood professionals and parents. The Early Childhood segment also provides information to teachers and other education professionals regarding the development of children from infancy through age eight. The Elementary School segment sells school supplies and other products specifically targeted for use by children in kindergarten through sixth grade to elementary schools, teachers and other education organizations for fundraising activities.
Revenues and operating income by segment follows (in thousands):
The Early Childhood segment performs limited administrative activities, including certain accounting and information system functions, on behalf of the Elementary School segment. Such inter-segment charges are based on estimates of its actual costs for such activities. Inter-segment charges amounted to $512,000, $407,000, and $580,000 for the years ended December 31, 2005, 2004, and 2003, respectively. The Company allocates income tax expense for the current year based on a percentage of each segment’s pre-tax income. The non-recurring adjustments in 2003 related to the change in tax law and adjustment to the deferred tax valuation allowance directly related to the Early Childhood segment and therefore the benefit of the adjustments is reflected entirely in that segment.
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for the reporting by public business enterprises of information about operating segments, products and services, geographic areas, and major customers. The methodology for determining the information reported is based on the organization of operating segments and the related information that the Chief Operating Decision Maker (CODM) uses for operational decisions and assessing financial performance. The Company’s Chief Executive Officer (CEO) is considered the Company’s CODM. For purposes of making operating decisions and assessing financial performance, the Company’s CEO reviews financial information for the Early Childhood segment and the Elementary School segment.
The following classes of similar products accounted for 10% or more of the Company’s total revenues during the fiscal year ended December 31, 2005, 2004 and 2003: arts and crafts products, which accounted for 32.6%, 31.0% and 33.0% of the Company’s total revenues during 2005, 2004 and 2003, respectively; furniture, which accounted for 23.9%, 23.0% and 18.0% of the Company’s total revenues during 2005, 2004 and 2003, respectively; and SchoolWrapPacs®, which accounted for 19.8%, 22.0% and 26.0% of the Company’s total revenues during 2005, 2004 and 2003, respectively. The Company’s arts and crafts products and furniture are sold through the Early Childhood segment, while the SchoolWrapPacs® are sold through the Elementary School segment.
The Company had no customer comprising greater than 10% of its revenue or accounts receivable as of and for the years ended December 31, 2005, 2004 or 2003.
The segment asset information available is as follows:
(18) Quarterly Information (Unaudited)
Excelligence Learning Corporation
Schedule II
Valuation and Qualifying Accounts