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 2004, 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, 2004, the Company distributed over 2.6 million Discount School Supply catalogs. In addition, the Company mailed four different specialty catalogs, each of which focused on a separate 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.
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 expiring in June 2007, one for approximately 17,000 square feet and one for approximately 9,000 square feet. The Company does not own any real property and leases the following other materially important facilities:
Item 3.
Item 3. Legal Proceedings.
On January 18, 2005, defendants in Excelligence Learning Corporation v. Oriental Trading Company and Teresa Martini (Case no. 03-04947-JF(RS) in the U.S. District Court for the Northern District of California) filed
a bill of costs and motion for attorneys’ fees from the Company. In its action, the Company had asserted claims that included theft of trade secrets, trade dress infringement and copyright infringement against a former employee (Martini) it alleged had taken trade secrets and used them to the benefit of her new employer (Oriental Trading Company). On December 20, 2004, the District Court entered summary judgment in favor of defendants. In their bill of costs, defendants seek approximately $430,000 and, in their attorneys’ fees motion, defendants seek approximately $1.8 million. Defendants’ bill and motion have not yet been heard, and the Company intends vigorously to appeal the adverse summary judgment decision. While the final outcome of these proceedings cannot be determined at this time, based on information presently available, the Company believes that the final outcome of such proceedings will not have a material adverse effect upon its results of operations or financial condition. However, the Company’s belief regarding the likely outcome of such proceedings could change in the future and an unfavorable outcome could have a material adverse effect upon its liquidity, results of operations or financial condition.
Aside from the above-referenced litigation, 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 other 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 2004.
PART II.
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
The Company’s common stock is currently traded on The Nasdaq SmallCap Market under the symbol “LRNS.” The following table sets forth the high and low price per share of the Company’s common stock during fiscal year 2004 and 2003:
On March 14, 2005, there were 8,935,124 outstanding shares of the Company’s common stock held by 152 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 2004.
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 years ended December 31, 2001 and 2000 reflect 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 and 2000 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 and 2000, respectively, 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:
·
its Discount School Supply catalog, through which the Company develops, markets and sells educational products to early childhood professionals and consumers;
·
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;
·
its ECMD catalog, through which the Company markets and sells furniture and equipment to early childhood professionals; and
·
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, 2004, numbered 63 people.
In fiscal year 2004, 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.
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, Excelligence 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 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.
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 had previously disclosed that it values inventories at the lower of cost or market, using only the first-in, first-out method. There is no impact or change to the Company’s financial results as a result of adjusting this disclosure.
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.
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, 2004. 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 2003 or 2002.
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 $121.3 million, $109.9 million and $100.8 million for 2004, 2003 and 2002, respectively. The increase in revenue from 2003 to 2004 of 10.3% was primarily due to growth of 16.1%, or $12.6 million, in the Early Childhood segment. Overall growth in the Early Childhood segment was achieved through new product offerings, new customer solicitation and improved sales and marketing strategies. The Elementary School segment’s revenue decreased by 4.0%, or $1.3 million, from 2003 to 2004, primarily due to order fulfillment challenges related to the consolidation of warehouses at the beginning of the year. The Company has taken steps to correct these fulfillment challenges and believes that the Elementary School segment’s processes will be operating effectively in 2005. The increase in revenue from 2002 to 2003 of 9.1% was primarily due to growth of 11.8%, or $8.3 million, in the Early Childhood segment.
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 1. Risk Factors.”
Gross Profit
Gross profit was $41.2 million, $39.5 million and $36.3 million for 2004, 2003 and 2002, respectively. The increase in gross profit in 2004 of $1.6 million was primarily due to an increase in gross profit of 10.1%, or $2.9 million, in the Early Childhood segment. This increase in gross profit within the Early Childhood segment was achieved through effective sales and marketing strategies. The increase in gross profit in 2003 of $3.2 million was primarily due to revenue growth of 11.8%, or $8.3 million, within the Early Childhood segment.
Gross profit as a percentage of sales was 33.9%, 35.9% and 36.0% for 2004, 2003 and 2002, respectively. 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. Gross profit as a percentage of sales remained relatively stable in 2003 when compared to 2002.
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, 2004, 2003 and 2002 was $7.6 million, $6.5 million and $6.5 million, respectively, or 6.3%, 5.9% and 6.4% as a percentage of sales, respectively. The amount of shipping costs related to shipments made directly from vendors to customers for the years ended December 31, 2004, 2003 and 2002 was $4.5 million, $3.2 million and $2.5 million, respectively, or 3.7%, 2.8% and 2.5% 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 $37.9 million, $34.6 million and $32.6 million for 2004, 2003, and 2002, respectively.
The $3.3 million increase in selling, general and administrative expenses in 2004 was attributable to an increase of $3.4 million in the Early Childhood segment offset by savings of approximately $149,000 in the Elementary School segment. The increase in the Early Childhood segment was primarily related to legal fees 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 $500,000 related to increased headcount to strengthen its merchandising and marketing efforts. The increase in selling, general and administrative expenses in 2003 was attributable to the costs associated with introducing a new catalog initiative, as well as increased wages and insurance costs, in the Early Childhood segment, and an increase in wages as a result of an increase in the number of sales representatives, an increase in temporary help hired for the back-to-school season and an increase in insurance costs in the Elementary School segment.
The Company does not anticipate significant personnel reductions in 2005. 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 $173,000, $279,000 and $288,000 for 2004, 2003, and 2002, 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 $89,000, $261,000 and $428,000 for 2004, 2003 and 2002, respectively. The decrease in interest expense in 2002 through 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 (the “GMAC Facility”). This was achieved by the Company’s improved cash management.
Income Taxes
Income tax expense was $1.1 million in 2004, income tax benefit was $3.6 million in 2003, and income tax expense was $548,000 in 2002. In 2004, the Company’s tax rate was in line with the statutory tax rate, while in 2003 the income tax benefit was lower than the statutory tax 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. 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 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. Income tax expense in 2002 was lower than the statutory tax rate primarily due to the reduction of the deferred tax valuation allowance.
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 January 2003, the Financial Accounting Standards Board (FASB) issued FIN 46, “Consolidation of Variable Interest Entities,” an Interpretation of Accounting Research Bulletin 51, “Consolidated Financial Statements.” FIN 46 addresses the consolidation by business enterprises of variable interest entities as defined in the interpretation. FIN 46 expands disclosure if an enterprise consolidates a variable interest entity, and the interpretation requires disclosure for those companies that hold significant variable interests in a variable interest entity but are not required to consolidate that interest. In December 2003, the FASB issued FIN 46R, which made certain amendments to FIN 46. The revision clarified the definition of a business as a variable interest entity. The revision also delayed the effective date of certain provisions of the interpretation from the first reporting period following December 15, 2003 to the first reporting period ending after March 15, 2004. The Company does not have any variable interest entities, and, therefore, the adoption of FIN 46 has not had a material impact on its consolidated financial statements.
In November 2004, the FASB issued SFAS No. 151, Inventory Costs-an amendment of ARB No. 43, Chapter 4. SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). SFAS No. 151 requires that those items be recognized as current period charges. Additionally, SFAS No. 151 requires that allocation of fixed production overhead to the cost of conversion be based on the normal capacity of the production facility. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. The Company does not expect the adoption of this provision to have a material effect on its consolidated financial statements.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB SFAS No. 95, Statement of Cash Flows. The approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires that all share-based payments to employees, including grants of employee stock options, be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS No. 123 (R) must be adopted no later than July 1, 2005. Early adoption is permitted in periods in which financial statements have not yet been issued. The Company expects to adopt SFAS No. 123(R) on July 1, 2005. The impact of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted SFAS No. 123(R) in prior periods using the Black-Scholes valuation model, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net income and earnings per share in Note 2 to the Company’s consolidated financial statements. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement may reduce the Company’s net operating cash flows and increase its net financing cash flows in periods after adoption.
Liquidity and Capital Resources
On September 29, 2003, the Company entered into a $20.0 million secured credit facility with Bank of America, N.A. (the “Bank of America Facility”). The Bank of America Facility replaced the Company’s GMAC Facility. Historically, the Company’s primary cash needs have been for operations, capital expenditures and acquisitions. The Company’s primary source of liquidity through September 29, 2003 was the GMAC Facility. Since that time, the primary source of the Company’s liquidity has been the Bank of America Facility. During the last quarter of 2004, pursuant to the financing schedule contained in the Bank of America Facility, the amount available under the facility stepped down to $19.4 million. As of December 31, 2004, the Company had net working capital of $25.0 million.
During 2004, the Company’s operating activities provided $581,000 of cash, representing a decrease of $2.2 million over 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.
During 2002, the Company’s operating activities provided $7.7 million of cash. The cash provided from operating activities was primarily related to operating income and changes in working capital. The Company used $1.1 million in cash for investing activities in 2002, with which the Company purchased property and equipment in the amount of $1.2 million and received payment on a receivable from a related party. The Company used $5.6 million in cash for financing activities, primarily for principal payments made against the GMAC Facility.
The Bank of America Facility includes a $15.0 million revolving line of credit with a maturity date of October 1, 2005 and an interest rate of LIBOR plus 1.75% (4.525% at December 31, 2004). The Bank of America Facility also includes up to $4.4 million through a reducing revolving term loan with a maturity date of October 1, 2008 and an interest rate of LIBOR plus 2.00% (4.775% at December 31, 2004). The Bank of America Facility is secured by substantially all of the Company’s assets, including receivables, inventory, equipment and intellectual property. As of December 31, 2004, the Company had no borrowings and available credit of $19.4 million under the Bank of America Facility.
The Bank of America Facility 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, 2004, the Company was in compliance with the financial covenants and limitations as set forth in the Bank of America Facility.
The following table summarizes the Company’s contractual obligations as of December 31, 2004 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, 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, 2004, the Company did not have any guarantees, including loan guarantees, standby letters of credit or indirect guarantees.
Business Outlook
The following forward-looking statements reflect the Company’s expectations for the full year 2005. Actual results may differ materially from these expectations. Certain factors that could cause actual results to differ
materially from the Company’s expectations are discussed in “Item 1. Risk Factors.” The Company does not undertake to update these expectations, except to the extent that the Company is required to do so.
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.
For fiscal year 2005:
·
Net revenues are expected to be between $125.0 and $135.0 million; and
·
Operating income is expected to be between $5.0 and $8.0 million.
While the Company has historically provided EBITDA guidance, and believes that it can be a useful measure for gauging its overall performance and results of operations, it believes that operating income is a stronger indicator of the Company’s financial health and growth going forward. The Company, therefore, no longer provides future guidance on EBITDA.
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, 2004, 44% of the Company’s consolidated 2004 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 1. 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. 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, 2004, the Company had no borrowings under the Bank of America Facility and available borrowing capacity of $19.4 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.
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by SEC Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the fiscal year covered by this report. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.
There has been no change in the Company’s internal controls over financial reporting during the Company’s most recent fiscal year that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.
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 2005 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 2005 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 2005 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 2005 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 2005 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 the Registrant’s Registration Statement on Form S-4 filed with the Commission on January 9, 2001 (File No. 333-53454).
(4)
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).
(5)
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).
(6)
Incorporated by reference from the Registrant’s Registration Statement on Form S-8 filed with the Commission on July 9, 2001 (File No. 333-64762).
(7)
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).
(8)
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).
(9)
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).
(10)
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).
(11)
Incorporated by reference from the Registrant’s Quarterly Report on Form 10-Q for the Quarter Ended March 31, 2002, filed with the Commission on May 15, 2002 (File No. 000-32613).
(12)
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).
(13)
Incorporated by reference from the Registrant’s Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2002, filed with the Commission on March 7, 2003 (File No. 000-32613).
(14)
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).
(15)
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).
(16)
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).
(17)
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).
(18)
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).
(19)
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).
(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/ DIANE KAYSER
Diane Kayser
Executive Vice President and Chief Financial Officer
Dated: March 16, 2005
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 balance sheets of Excelligence Learning Corporation and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, equity and cash flows for each of the years in the three-year period ended December 31, 2004. 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 preceding 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, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, 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
March 11, 2005
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) 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, 2004. 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 2003 or 2002.
(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, 2004 and 2003, cash equivalents consisted of an overnight investment account in the amount of $2.7 million and $3.6 million, respectively.
(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 $4.6 million, $3.3 million and $2.3 million for the years ended December 31, 2004, 2003 and 2002, 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 $1.5 million, $1.4 million and $1.3 million for the years ended December 31, 2004, 2003 and 2002, 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 $7.1 million, $7.0 million, and $6.4 million for the years ended December 31, 2004, 2003 and 2002, 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:
(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
The basic and diluted net income per share information for the years ended December 31, 2004 and 2003 included in the accompanying statements of operations is based on the weighted average number of shares outstanding during the period.
Potential dilutive securities consisting of 535,858 and 578,205 shares issuable upon the exercise of stock options have been excluded in the computation of diluted net income per share for the years ended December 31, 2004 and 2003, respectively, as the effect of including unrecognized compensation cost in the treasury stock method would be anti-dilutive.
(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 January 2003, the Financial Accounting Standards Board (FASB) issued FIN 46, “Consolidation of Variable Interest Entities,” an Interpretation of Accounting Research Bulletin 51, “Consolidated Financial Statements.” FIN 46 addresses the consolidation by business enterprises of variable interest entities as defined in the interpretation. FIN 46 expands disclosure if an enterprise consolidates a variable interest entity, and the interpretation requires disclosure for those companies that hold significant variable interests in a variable interest entity but are not required to consolidate that interest. In December 2003, the FASB issued FIN 46R, which made certain amendments to FIN 46. The revision clarified the definition of a business as a variable interest entity. The revision also delayed the effective date of certain provisions of the interpretation from the first reporting period
following December 15, 2003 to the first reporting period ending after March 15, 2004. The Company does not have any variable interest entities, and, therefore, the adoption of FIN 46 has not had a material impact on its consolidated financial statements.
In November 2004, the FASB issued SFAS No. 151, Inventory Costs-an amendment of ARB No. 43, Chapter 4. SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). SFAS No. 151 requires that those items be recognized as current period charges. Additionally, SFAS No. 151 requires that allocation of fixed production overhead to the cost of conversion be based on the normal capacity of the production facility. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. The Company does not expect the adoption of this provision to have a material effect on its consolidated financial statements.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB SFAS No. 95, Statement of Cash Flows. The approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires that all share-based payments to employees, including grants of employee stock options, be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS No. 123 (R) must be adopted no later than July 1, 2005. Early adoption is permitted in periods in which financial statements have not yet been issued. The Company expects to adopt SFAS No. 123(R) on July 1, 2005. The impact of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted SFAS No. 123(R) in prior periods using the Black-Scholes valuation model, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net income and earnings per share in Note 2 to the Company’s consolidated financial statements. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement may reduce the Company’s net operating cash flows and increase its net financing cash flows in periods after adoption.
(3) Business Combination
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 listed on the balance sheet as of December 31, 2003 were reclassified to equity in 2004.
The allocation of the purchase price of $1.2 million plus transaction costs of $71,000 is summarized as follows (in thousands):
(4) Accounts Receivable
Accounts receivable consists of the following amounts (in thousands):
(5) Inventories
Inventories, stated at lower of cost or market, consist of the following amounts (in thousands):
(6) Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consist 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, 2004 and 2003, the major classes of intangible assets were as follows (in thousands):
Total amortization expense on intangible assets for the years ended December 31, 2004, 2003 and 2002 was $173,000, $279,000, and $288,000, respectively. The carrying amount of goodwill was $5.9 million at December 31, 2004 and 2003.
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):
(9) Accrued Expenses and Merger Integration Charges
Accrued expenses consist of the following amounts (in thousands):
In conjunction with the Combination, the Company terminated certain SmarterKids.com employees and determined that the acquired lease for its Needham facility was an unfavorable lease. As a result, liabilities of $1.5 million and $1.1 million were recorded for severance and unfavorable leases in 2001, respectively.
In the fourth quarter of 2001, the Company approved a restructuring plan to aid in the reduction of operating costs. Specifically, the Company closed its Needham, Massachusetts facility in January 2002. The closure of the Needham facility was designed to consolidate information systems and marketing functions in Monterey, California and reduce the administrative costs associated with operating an additional facility.
Restructuring and related charges of $1.8 million were expensed in 2001. Of this amount, $1.3 million related to exit costs associated with the Needham lease and various equipment leases that were no longer going to be utilized in the Company’s operations. The remaining $469,000 was related to other merger and integration costs. No additional accrual for severance was made at the end of the year; however, approximately 22 employee positions were reduced in early 2002 as a result of the closure of the Needham facility. During the year ended December 31, 2002, the Company paid $401,000 and $1.3 million relating to severance and Needham facility costs, respectively. Of these costs, $226,000 related to severance for termination announced in the first quarter of 2002 and therefore was recorded as an expense in the first quarter of 2002. During the third quarter of 2002, the Company determined that based on current real estate market conditions in Needham, Massachusetts, its assumptions for sublease income should be reduced and an additional lease abandonment charge of $653,000 was recorded in selling, general and administrative expenses. In 2003, no other additional charges related to the Needham lease were determined to be necessary and the Company paid $938,000 related to Needham facility costs.
A rollforward of activity in merger integration related liabilities follows (in thousands):
(10) Credit Facility
On September 29, 2003, the Company entered into a $20.0 million secured credit facility with Bank of America, N.A. (the “Bank of America Facility”). The Bank of America Facility replaced the Company’s credit facility with GMAC Business Credit, LLC (the “GMAC Facility”). During the last quarter of 2004, pursuant to the financing schedule contained in the Bank of America Facility, the amount available under the facility stepped down to $19.4 million.
The Bank of America Facility includes a $15.0 million revolving line of credit with a maturity date of October 1, 2005 and an interest rate of LIBOR plus 1.75% (4.525% at December 31, 2004). The Bank of America Facility also includes up to $4.4 million through a reducing revolving term loan with a maturity date of October 1, 2008 and an interest rate of LIBOR plus 2.00% (4.775% at December 31, 2004). The Bank of America Facility is secured by substantially all of the Company’s assets, including receivables, inventory, equipment and intellectual property. As of December 31, 2004, the Company had no borrowings and available credit of $19.4 million under the Bank of America Facility.
The Bank of America Facility requires adherence to certain financial covenants and limitations related to capital expenditures and acquisitions during the term of the facility. As of December 31, 2004, the Company was in compliance with the financial covenants and capital expenditure and acquisition limitations as set forth in the Bank of America Facility.
(11) Related Party Transactions
The Company leases its Salinas paint manufacturing facility center from an entity comprised of its Chief Executive Officer and another significant stockholder. The lease expires on August 5, 2005 and calls for monthly rent payments of $24,885.
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 year ended December 31, 2004, the Company paid the entity an aggregate of $66,985.
(12) Income Taxes
The Company is taxed as a C corporation. 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 following table reflects actual income taxes based on the income tax status of the Company and its subsidiaries for the respective periods (in thousands):
The Company’s actual tax expense (benefit) differs from the statutory federal income tax rate of 35% for the years ended December 31, 2004, 2003 and 2002, as shown in the following schedule (in thousands):
The following table displays the tax effects of temporary differences (in thousands):
The valuation allowance is 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. The reduction in the 2004 beginning valuation allowance was due to the write-off of certain deferred tax assets that had been previously reserved by the Company. The reduction in the valuation allowance in 2003 and 2002 was related to assets acquired in the Combination for which the Company determined the allowance was no longer necessary. This adjustment has been reflected as a reduction to income tax expense because the long-lived assets acquired in the Combination were impaired as of December 31, 2001.
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.
Due to the nontaxable LLC status of Earlychildhood, no deferred tax assets or liabilities were established relating to the differences between book and tax basis of its assets and liabilities prior to April 30, 2001. As of
April 30, 2001, the net tax basis of Earlychildhood’s assets and liabilities exceeded the net book basis by $934,000. As a result of the Combination, differences between the book and tax basis became subject to income taxes, resulting in a tax benefit of $365,000.
(13) 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 $13,000 in 2004, as a contribution to the Plan. Participants who are 50 years or older had the option to defer an additional $3,000 in 2004. The Company matches 15% of employee contributions to the Plan up to a maximum of 6% of their compensation. The Company suspended matching participants’ contributions to the Plan from February through September 2002.
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 $44,000, $60,000, and $30,000 for the years ended December 31, 2004, 2003 and 2002, 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.
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.
The following table summarizes stock option activity for the three years ended December 31, 2004:
The following table summarizes significant ranges of outstanding and exercisable options at December 31, 2004:
The weighted average fair value per share of options granted during 2004, 2003 and 2002 was $3.40, $5.58 and $2.47, respectively. The fair value of these options was estimated using the Black-Scholes model with the following weighted average assumptions:
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 number of shares purchased through the plan for fiscal year 2003 was 21,652, with an average price of $1.91. For fiscal year 2002, 7,710 shares were purchased through the plan, with an average price of $1.05. The Company suspended the 2001 Employee Stock Purchase Plan in August 2003.
(14) 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, 2004 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 are recognized on a straight-line basis over the term of the lease. Total rental expense under operating leases was $3.7 million, $3.9 million and $4.0 million for December 31, 2004, 2003, and 2002, respectively.
As stated in Note 11, the Company leases one of its warehouse facilities from a company owned by its Chief Executive Officer and one of its other significant stockholders.
(15) Segment Information
The Early Childhood segment includes the brand names Discount School Supply, SmarterKids.com, 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 professional regarding 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.
The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies in the Company’s annual report filed on Form 10-K. The Company’s supplemental profit measure is EBITDA. EBITDA, a non-GAAP financial measure which the Company believes is a meaningful supplemental measure of its operating performance, is calculated by adding back to net income (loss): net interest, income taxes, depreciation and amortization. EBITDA is presented because the Company believes that EBITDA, when combined with other measures, can be a useful measure of its overall performance and results of operations. In addition, the Company uses the measure and believes that it is also used by lenders, analysts, investors and others as an indication of the Company’s ability to service debt and fund future capital expenditure requirements. EBITDA information should not be considered an alternative to any measure of performance as promulgated under generally accepted accounting principles (such as operating income or net income) nor should it be considered as an indicator of the Company’s overall financial performance. The Company’s calculations of EBITDA may be different from the calculations used by other companies and
therefore comparability may be limited. Revenues by segment and reconciliation of net income (loss) to EBITDA 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 $407,000, $580,000, and $577,000 for the years ended December 31, 2004, 2003, and 2002, 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. Prior to fiscal year 2003, no allocation of income tax was made to the Elementary School segment.
The Company had no customer comprising greater than 10% of its revenues or accounts receivable as of and for the years ended December 31, 2004, 2003 or 2002.
The segment asset information available is as follows:
(16) Quarterly Information (Unaudited)
Excelligence Learning Corporation
Schedule II
Valuation and Qualifying Accounts