ITEM 1.
BUSINESS
As used in this report, the terms “we,” “us,” “our,” the “Company”, and “BabyUniverse” refer to BabyUniverse, Inc. and its subsidiaries, unless otherwise expressly stated or the context otherwise requires.
Introduction
BabyUniverse is a leading Internet content, commerce and new media company in the pregnancy, baby and toddler marketplace. Through its websites BabyUniverse.com and DreamtimeBaby.com, the Company is a leading online retailer of brand-name baby, toddler and maternity products in the United States. Through its websites PoshTots.com and PoshLiving.com, the Company has extended its offerings in the baby and toddler market as a leading online provider of luxury furnishings to the country’s most affluent female consumers. Through its websites PoshCravings.com, ePregnancy.com and the recently introduced BabyTV.com, BabyUniverse has also established a recognized platform for the delivery of content and new media resources to a national audience of expectant parents.
BabyUniverse is pursuing a dual strategy of organic growth and acquisition growth that is designed to establish BabyUniverse as the leader in the online baby marketplace. Beyond the baby segment, the Company intends to leverage its efficient and growing e-commerce platform to acquire other female-oriented e-commerce, marketing and new media companies. The overall objective of BabyUniverse is to establish a market-leading e-commerce and new media business focused on the high-growth female marketplace.
To further this objective, our stock began trading on The Nasdaq Capital Market on March 27, 2006, after trading on the American Stock Exchange since August 3, 2005. At the same time, we changed our trading symbol from “BUN” to “POSH.” We believe this change is more reflective of our strategy to appeal to a broader female marketplace by leveraging our strong e-commerce business model with e-content and new media initiatives focused on this country’s most affluent online female consumers.
We were incorporated in Florida on October 15, 1997, as Everything But The Baby Inc. and initially operated the domain name www.everythingbutthebaby.com. In 1999, we began to market our products under the BabyUniverse brand at www.babyuniverse.com, and we changed our corporate name to BabyUniverse, Inc. on November 16, 2001.
We believe that we are one of the largest online retailers of baby, toddler and maternity products in terms of product offerings and revenues. As an industry leader, we have grown our business internally since inception by increasing our presence in what we have identified to be the largest and most efficient Internet shopping portals, as well as through search engine marketing, resulting in increased traffic to our websites. We have also attempted to improve our sales conversion rate by broadening our product offerings and by actively managing the placement of the best-selling products on our websites.
The market for online retailers offering baby, toddler and maternity related products is highly fragmented, with a significant number of small competitors representing a significant percentage of total segment sales. We believe that our seasoned senior management team and our scalable business architecture make us well-suited to acquire both large and small industry competitors. As part of our acquisition strategy, we intend to preserve the goodwill and marketing relationships of acquired companies as necessary to maintain and grow market share. In addition, we may acquire companies that market products predominantly to women over the Internet, or companies that enhance our ability to market products to women.
Our e-commerce offerings include over 35,000 products from over 600 manufacturers that are presented in easy-to-use online shopping environments that include baby, toddler and maternity accessories, apparel, bedding, furniture, toys and gifts. These products are available in a variety of styles, colors and sizes which account for over 750,000 stock keeping units (“SKUs”). We also provide expert buyer’s guides and product descriptions to assist our customers with finding quality products and to help parents make informed decisions about their babies’ and toddlers’ needs and safety.
Growth Strategy
The overall objective of BabyUniverse is to establish a market-leading e-commerce and new media business focused on the high-growth female marketplace. Beyond the baby related e-commerce segment, the Company intends to leverage its efficient and growing e-commerce platform to acquire other female-oriented e-commerce, marketing and new media companies. We intend to achieve this objective by pursuing a balanced growth strategy that contemplates both organic and external growth initiatives. Our organic growth strategy will focus on initiatives that will build on our existing business strengths while our external growth strategy will focus on consummating strategic acquisitions of companies focused on the high-growth female marketplace.
Organic Growth Strategy
We intend to pursue various initiatives associated with our organic growth strategy that are designed to enhance our market presence, expand our customer base and provide a superior online baby, toddler and maternity shopping experience. Key elements of our organic growth strategy include the following:
Build Brand Recognition. We will continue taking steps to have our websites appear among the first several websites naturally listed in search engine results. We will also continue to build our brands primarily through online marketing and advertising. These efforts currently consist largely of the purchase of keywords from large search providers, such as Google, Yahoo and MSN, which result in advertisements for our websites being displayed next to search results. In addition, we also aggressively participate in many of the major online shopping portals such as Shopzilla, Amazon, MSN Shopping, and Shopping.com. Most of our advertising expenditures are on a ‘pay for click’ basis, and smaller portions are based on negotiated rates or percentages of sales. We have established and are continuing to develop brands based on trust, guidance and value, and we believe our customers view BabyUniverse as a trusted authority on baby, toddler and maternity products. Our goal is for consumers to seek the BabyUniverse and our other brands and consistently revisit our websites whenever they purchase baby, toddler and maternity products.
Improve Our Sales Conversion Rate. As we have hundreds of thousands of visitors to our websites each month, small changes in the conversion rate, or the percentage of visitors to our websites who make a purchase, can have a significant impact on sales. In many of our marketing programs, we incur expenses based on the number of people that click on advertisements that link them to our websites. When customers click on these advertisements and do not consummate a purchase, we incur expense but do not generate immediate sales. We believe that we can improve our sales conversion rate by offering a wider range of products and by actively managing the placement of our best-selling products on our websites. We also believe that by offering a wider range of products we decrease the likelihood that customers will leave our websites to continue their shopping elsewhere.
Focus on the Customer Experience to Build Customer Loyalty. We continue to refine the customer service we provide in every step of the purchase process, from our websites to our customer support and fulfillment operations. The customer experience is designed to empower our customers with knowledge and confidence as they evaluate, select and purchase baby, toddler and maternity products. We intend to continue to allocate significant resources to the development and expansion of our customer service function. These efforts are focused on promoting customer loyalty and building repeat purchase relationships with our customers.
Increase Our In-House Fulfillment of Best-Selling Products. In January 2006, we opened a 23,000 square foot distribution center in Las Vegas, Nevada to replace our much smaller warehouse in Ft. Lauderdale, Florida. We generally incur lower overall costs on those products we process through our warehouse, as our in-house distribution costs are lower than markups imposed by our distribution partners or drop shippers. We believe that our distribution center allows us to increase our product volume in support of our rapid growth in sales. As we identify our best-selling products, which represent low inventory capital risk, we selectively make bulk inventory acquisitions to take advantage of these in-house efficiencies. We believe that expanding our in-house distribution volume of these best-selling products will allow us to increase our gross margins.
Explore Additional Marketing Channels. Although almost all of our marketing presence is online, we will continue exploring innovative methods of reaching additional potential customers through offline marketing initiatives. Many forms of offline advertising, such as print advertising in magazines, require large initial expenditures. Furthermore, it is difficult to track the number of customers generated from these types of advertisements. We intend to seek other forms of partnered offline advertising. Our plans include minimizing or eliminating the need for large initial expenditures either by sharing marketing expenses with manufacturers or by offering joint promotions in concert with our advertising partners.
External Growth Strategy
While our historical growth through 2005 had been primarily organic, we initiated a growth strategy in 2006 based on a balanced combination of organic growth and external growth. We expect that our external growth strategy will be characterized by strategic industry acquisitions of e-commerce, marketing and new media companies that are broadly focused on the high-growth female marketplace. Accordingly, we intend to leverage the skill sets of our management team and board of advisors and our scalable business architecture to actively evaluate potential e-commerce and content focused acquisition candidates and consummate merger and acquisition transactions as an important and on-going component of our business model.
Impact of the Year 2000 Downturn. In the late 1990’s, capital markets were highly receptive to technology companies, including e-commerce companies that enjoyed ready access to capital at attractive valuations. In the ensuing period of extreme volatility in e-commerce company valuations, however, very few e-commerce companies were able to raise capital in either public or private markets. It is important to realize that this market downturn represented a sharp decline in valuations only, not a decline in overall e-commerce business activity. The e-commerce industry grew quickly during and since this period, as consumers have migrated more and more from traditional retail points-of-purchase to the Internet.
In spite of the perceived lack of interest by investors, certain types of e-commerce companies continue realizing significant growth, a direct reflection of consumers’ increasing demands for convenient and secure Internet-based shopping. As a result of these somewhat contradictory market forces - increased demand for e-commerce products against a decreased demand for e-commerce investments - many of the e-commerce companies that continue to operate today have successfully adapted to capital-constrained operating models that require a more conservative balance between growth and profitability than was demonstrated by the e-commerce pioneers of the late 1990’s. We believe that we can identify attractive acquisition candidates from within this group of surviving market participants.
Acquisition Environment and Prospects. We have engaged, and expect to continue to engage, in preliminary discussions with prospective acquisition candidates and to continue to develop an analysis of the strategic industry acquisition landscape. These discussions traditionally have focused primarily on Internet retailers of baby related products which are smaller than us in terms of revenues and content sites that focus on a female audience. These discussions and analyses suggest the following:
Growth Capital and Exit Opportunities are Scarce. The positive trends in the e-commerce industry have not yet resulted in a recognizable increase in private equity funding of baby, toddler and maternity online retail companies. Public and private capital markets are generally difficult to access, especially for those companies with inadequate board sponsorship or unproven public market leadership. Furthermore, as many of these potential targets have not attracted public or private investment in recent years, they tend not to have professional investors on their boards of directors or in their management teams. Also, large strategic acquirers are rarely attracted to developing companies of small size, a characteristic that describes much of the broader baby, toddler and maternity e-commerce industry.
We Possess Characteristics that Make Us an Attractive Acquirer. Based on discussions with companies that we have acquired, and preliminary discussions with potential acquisition targets, management believes that targets will view our plan as attractive primarily because of the following:
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our sophisticated and seasoned management team and board of directors, who have significant experience working for and with companies engaged in substantial acquisition programs;
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our efficient business model, which is characterized by high inventory turnover and an ability to rapidly expand product offerings with relatively minimal capital expenditures;
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our well-defined growth strategy; and
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a visible exit strategy that offers cash or publicly traded securities.
Structure of Transactions Contemplated. We intend to acquire either the equity or the assets of acquisition targets. Depending on the needs of our targets, we anticipate using both cash and stock as consideration for these acquisitions.
Acquisition Parameters. We intend to acquire companies that have the potential for significant growth, achievable independently or as a result of cross-marketing strategies that we implement subsequent to the acquisition. We will focus on companies that have exhibited historical profitability or those that can combine with our company to become profitable. Targeted companies will include direct competitors with broad product offerings, as well as those that focus on a specific product niche. Characteristics of targets that we would particularly value include an established strong domain name or brand recognition, mature Internet marketing relationships, stable supplier relationships and defendable market positions.
Recent Developments. On March 13, 2007, the Company entered into a definitive Agreement and Plan of Merger with eToys Direct, Inc. (See Business - Recent Developments - Strategic Alternatives) In the event that the merger transaction contemplated by this agreement is consummated, we intend to re-evaluate the Company’s overall external growth strategy in light of the interests of the combined company.
Recent Developments
Strategic Alternatives
On August 14, 2006, BabyUniverse announced that its Board of Directors decided to begin a process to explore strategic alternatives to enhance shareholder value including, but not limited to, the acquisition of a substantial private company, the acquisition of a complementary public company or a potential sale of the Company. On October 5, 2006, the Company announced that it had retained Banc of America Securities LLC as its financial advisor. There can be no assurance that a transaction will result from this process and the Company does not intend to disclose developments regarding its exploration unless and until the Company’s Board of Directors has approved a specific transaction.
On March 13, 2007, the Company entered into a definitive Agreement and Plan of Merger (the “Merger Agreement”) with eToys Direct, Inc. (“eToys Direct”), an e-commerce and direct marketer of toys and other youth-related products. Under the terms of the Merger Agreement, which has been approved by the Company’s Board of Directors, the Company will exchange shares of its Common Stock, par value $0.001 per share (the “Common Stock”), for all the outstanding shares of eToys Direct. Immediately following the merger contemplated by the Merger Agreement (the “Merger”), BabyUniverse shareholders at the time immediately prior to the Merger will own approximately one-third, and eToys Direct shareholders at the time immediately prior to the Merger will own approximately two-thirds, of the outstanding Common Stock.
The Company and eToys Direct have made customary representations, warranties and covenants to one another in the Merger Agreement. Consummation of the Merger is subject to certain conditions, including, among others, the approval of the Merger Agreement by the holders of the Common Stock, the repayment by the Company of all of its indebtedness for borrowed money outstanding as of the closing of the Merger, and the absence of any law or order prohibiting the consummation of the Merger. The Merger Agreement contains certain termination rights for both the Company and eToys Direct, and further provides that, upon termination of the Merger Agreement under specified circumstances, the Company may be required to pay eToys Direct a termination fee of $1,567,178, and reimburse eToys Direct for the expenses incurred by it in connection with the transaction in a maximum amount of $1,500,000.
Acquisitions
On September 13, 2005, we acquired all of the shares of outstanding common stock of Huta Duna, Inc., which through the website, DreamtimeBaby.com, is a growing online retailer of brand name baby products that is focused primarily on high-quality bedding products. The Company acquired the shares of Huta Duna common stock in exchange for approximately $6.4 million in cash and 53,165 shares of the Common Stock.
On January 13, 2006, through a wholly owned subsidiary (“PoshTots”), we acquired substantially all of the assets of Posh Tots, LLC in exchange for $6.0 million in cash, a Promissory Note for $6.0 million, 237,248 shares of the Common Stock and warrants to purchase 110,000 shares of the Common Stock at a price of $8.10 per share. Through its primary website, www.PoshTots.com, the Richmond, Virginia-based PoshTots has long been recognized as a leading online retailer of high-end, artisan-crafted furniture to this country’s most affluent new mothers. Beyond the baby and children’s segments, PoshTots recently extended its brand with the Fall 2005 introduction of a new website, www.PoshLiving.com, offering designer quality home furnishings to its existing and growing base of affluent, predominantly female, customers. In March 2006, Posh Tots introduced another new website, www.PoshCravings.com, designed as a content driven initiative targeted at the affluent female customer base already developed by PoshTots.
On June 15, 2006, the Company acquired certain assets related specifically to the business of ePregnancy.com and ePregnancy Magazine. The selected assets acquired include the URL www.ePregnancy.com, the ePregnancy trademark, a related online community website, message boards, and an expansive archive of content. The magazine’s prior owners discontinued publication of ePregnancy Magazine and the final published issue was distributed in late April as the May 2006 issue. BabyUniverse intends to focus its efforts on growing and supporting the online community at ePregnancy.com and does not intend to revive the magazine. The acquisition of these assets furthers the overall objective of BabyUniverse, which is to establish a market-leading e-commerce and new media business focused on the high-growth female marketplace.
BabyTV.com
In December 2006 we launched our flagship new media venture, BabyTV.com, the Internet’s first integrated television-style broadcast channel and social networking community focused on the needs of new and expectant parents. BabyTV.com is delivered through an interactive format in which the consumer can tune in to broadcast-quality live and pre-recorded streaming television, interact through live events, respond to synchronized and targeted advertisements, engage in e-commerce transactions, browse links on the Web, and participate in BabyTV.com’s community features, without ever leaving the integrated broadcast platform.
The primary goal of BabyTV.com, and our other content sites, PoshCravings.com and ePregnancy.com, is to increase revenues from advertisers. We also intend BabyTV.com to build for our e-commerce sites the kind of loyalty with consumers that can be difficult to achieve in a pure e-commerce environment and to become a valuable driver of the BabyUniverse business strategy.
BabyTV.com has already partnered with the acclaimed women’s media company Oxygen Media Interactive, Inc., as well as video-on-demand pioneer Alpha Mom TV, Inc., to bring a wealth of informative and entertaining programming to our viewers. Oxygen’s “Oh!Baby” video on-demand (VOD) programming contributes segments of their popular shows, with content celebrating the highs and lows of parenthood. Alpha Mom contributes a deep catalog of informative programming featuring recognized experts on important topics from pregnancy through early child development. We plan to utilize these partnerships to cross-market to the 1.7 million monthly unique visitors of BabyUniverse-owned e-commerce properties such as BabyUniverse.com, PoshTots.com and DreamTimeBaby.com, and to content properties such as PoshCravings.com and ePregnancy.com.
Amazon Content Agreement
In December 2006, we reached an agreement with Amazon.com, Inc. to provide the rich content of our Internet sites, PoshCravings.com and ePregnancy.com, to Amazon.com consumers through the Amazon Baby marketplace. ePregnancy.com, a leading resource for both the expectant mother and new moms, offers valuable expert information as well as a vibrant online community. PoshCravings.com, launched in March of 2006, has become a top style and trend destination for savvy moms and moms-to-be. Both sites boast a loyal following of visitors who seek the best advice, tips and trends as well as fabulous weekly giveaways.
Amazon is the first significant strategic relationship designed to support our long-communicated plan to transform BabyUniverse from a pure e-commerce company into a balanced content, commerce and new media concern. With an audience of more than 60 million active customer accounts, Amazon presents an opportunity for national brand prominence for our PoshCravings.com and ePregnancy.com content properties.
The Internet Shopping Experience
We have designed our online retail stores to be the primary source for consumers to purchase baby, toddler and maternity accessories, apparel, bedding, furniture, toys and gifts. We believe our attractive, easy-to-use websites offer consumers an enjoyable shopping experience as compared to traditional store-based retailers. A consumer shopping on our websites can, in addition to ordering products, browse the different departments of our stores, conduct targeted searches, view recommended products, visit our Gift Center, participate in promotions and check order status. In contrast to a traditional retail store, the consumer can shop in the comfort and convenience of his or her home or office.
Our efficient website designs and commitment to excellent customer service enable us to deliver a superior shopping experience to consumers, the key components of which include the following:
Convenient Shopping Experience. Our online stores provide customers with easy-to-use and easy-to-shop websites. They are available 24 hours a day, seven days a week and may be reached from the shopper’s home or office, or anywhere with Internet connectivity. Our hierarchical website designs and broad search ability make our websites easy to navigate and to find specific brands and product types. During regular business hours, our customer service is readily available to further assist in finding the right product or answering any questions. Our broad product selection and extensive distribution network enables us to meet the needs of our customers located throughout the United States and Canada, especially those in rural or other locations that do not have convenient access to physical stores. Our gift registries, flexible payment methods, and online transaction security complement our overall convenient shopping experience.
Extensive Product Selection and Innovative Merchandising. We offer a broader selection of baby, toddler and maternity accessories, apparel, bedding, furniture, toys and gifts than would be economical or practical to stock in a traditional store for all but our largest competitors. We provide consumers with a comprehensive selection of both traditional, well-known brands and select specialty brands. The merchandising and/or placement of product on our websites are designed to ensure that our customers immediately view the most popular products in each department. We continually monitor our customer buying habits to determine our best-selling products in each category. The most popular products are then featured on our homepage and in various locations throughout the website with the intent to increase our sales conversion rate. We also suggest complementary or other related purchases in an effort to cross-sell products across our departments and promote impulse purchases by customers. Finally, our range of helpful and useful shopping services, such as our gift registries, enable us to display and promote our product selection in a flexible and targeted manner.
Personalized Gift Registry. Our gift registries permit expectant parents to select the items that they wish to have their relatives and friends purchase and then permit the products to be purchased online from anywhere in the world for shipment to the registrant. We assist the registrants in notifying their relatives and friends of the registries by either sending an email announcement or by mailing to the registrants pre-printed invitation card inserts for distribution by the registrants themselves.
Efficient Browsing Features. Our websites offer visitors a variety of highlighted subject areas and special features arranged in a simple, easy-to-use format intended to enhance product search, selection and discovery. By clicking on the permanently displayed department names, the consumer moves directly to the home page of the desired department and can quickly view promotions, bestsellers and featured products. Customers can use a quick keyword search in order to locate a specific product and can also execute more sophisticated searches based on pre-selected criteria depending upon the department. In addition, customers can browse specifically designed pages dedicated to products from key national and/or specialty brands that we choose to feature.
Comprehensive Product Information. One of the advantages of an online retail store is the ability to provide more comprehensive product information and data. On our websites, customers can find detailed product information, including product descriptions, a list of accessories and related products that are available. We also offer buying guides, product comparisons, product specifications and instruction manuals so a customer can make an informed purchase decision. We also encourage customer feedback by allowing our customers to write product reviews.
High Level of Customer Service and Support. A key element of our sales strategy is our ability to provide a high level of customer service and support, including:
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knowledgeable customer service;
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product selection services and advice;
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online order tracking and email confirmation; and
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gift-wrapping.
We have historically maintained our customer service functions in-house instead of outsourcing these services. We believe that friendly and responsive customer service is an avenue for building brand recognition and customer loyalty. We have evaluated providers of outsourced customer service functions and may continue to do so in the future. We would only engage the services of an outsourced customer service provider if we felt that our expectations for a high level of customer service would be maintained. We believe that attentive, proactive customer service is an essential component of any e-commerce business model and, in particular, the baby product market requires superior customer service. Accordingly, we will continue allocating significant resources to the development and expansion of the customer service function.
Fulfillment Operations
Currently, we purchase and fulfill our products to our customers through the following methods:
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approximately 39% through the combination of our 23,000 square foot Las Vegas distribution center, and a third party warehouse and fulfillment center in St. Louis, Missouri;
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approximately 54% via drop ship arrangements with manufacturers and vendors, whereby customer orders that are placed through our websites are sent electronically to manufacturers or vendors that ship those orders directly to our customers; and
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approximately 7% through a fulfillment agent and a buying consortium, whereby customer orders that are placed through our websites are sent electronically to these entities that ship those orders directly to our customers.
As part of our organic growth strategy for the past several years, we have gradually increased the fulfillment of certain of our best-selling products through our distribution center from approximately 25% to 39%. With the opening of our larger Las Vegas distribution center in January 2006, which replaced our 6,000 square feet distribution center in Florida, we intend to continue to gradually increase the percentage of our orders fulfilled in-house.
Marketing and Advertising
Our marketing and advertising efforts have historically been almost entirely online initiatives, but we intend to aggressively pursue efficient methods of reaching additional potential customers through innovative offline advertising and marketing initiatives. In addition, PoshTots has historically utilized a printed catalog as one of its marketing channels, a practice that we expect to continue. We have developed a marketing strategy designed to increase brand recognition, generate consumer traffic, acquire customers, build a loyal customer base and maximize repeat purchases. Our primary target market is expectant parents, with women representing by far the largest segment of our customer base, and relatives and friends who purchase baby, toddler and maternity products. Our marketing initiatives primarily consist of the following:
Portal and Targeted Website Advertising. A primary vehicle for our online advertising is the optimized search results on websites with high traffic volumes. We currently maintain advertising relationships or have preferred placement agreements with many search engines, including MSN, Overture, Google, and Yahoo!, among others. Through these relationships, we advertise on websites that appeal to our target customer base.
Partnerships with High Traffic Shopping Sites. Due to our broad selection of product offerings and our expanding presence through multiple websites, we believe we are best able to support the baby product offerings of select high traffic shopping websites like Buy.com and Amazon.com. In March 2006, we signed an agreement with Buy.com as a fulfillment provider of baby related products. In December 2006, we reached an agreement with Amazon.com, Inc. to provide the rich content of our Internet sites, PoshCravings.com and ePregnancy.com, to Amazon.com consumers through the Amazon Baby marketplace. We will also continue to pursue agreements with other female oriented content based websites as their preferred e-commerce partner.
E-mail Marketing. We utilize an electronic direct marketing program to encourage repeat purchases and customer retention, generate referral business and provide access to increasing numbers of prospective customers. We recently implemented additional e-mail list marketing initiatives, which have been developed and used successfully by PoshTots.
Affiliate Program. We also acquire customers by offering a web-marketing affiliate program that is intended to extend the reach of our brand and draw consumers from a variety of other websites. By joining our web-marketing affiliate program, operators of other websites earn commissions and enhance their websites by providing their visitors access to our content and information as well as our extensive selection of baby and toddler products.
Printed Catalog. PoshTots has historically utilized a printed catalog as one of its marketing channels. We expect to continue this practice for PoshTots.com and to evaluate including a printed catalog as a marketing channel for our other websites.
Once a customer completes a purchase, we focus on establishing a continuing relationship with that customer in order to encourage repeat purchases. To acquire new customers, we leverage our relationships with existing customers by encouraging them to refer friends and family. We also utilize permission-based email marketing to non-buying visitors who indicate a desire to continue to be advised of our offerings.
Seasonality
We operate in the retail sales industry, which is seasonal and subject to general economic conditions, consumer spending and other factors. Our historical results of operations have been moderately seasonal, reflecting a general pattern of peak sales in mid-fourth quarter. Companies operating in the retail sales industry typically realize a disproportionate amount of their net sales during the fourth quarter of each calendar year. If our business begins to more closely reflect industry norms for seasonality, we may incur significant additional expenses during our fourth quarter, including higher inventory of product and additional staffing in our fulfillment and customer support operations, in anticipation of increased sales activity.
Competition
We operate in a highly competitive environment. We principally compete with a variety of mass merchandisers, discount stores, department stores, Internet retailers, specialty retailers and catalog merchandisers that offer products similar to or the same as our products. Increased competition may result in price reductions, reduced gross margins and loss of market share, any of which could seriously harm our financial condition and results of operations. We expect competition to intensify in the future because current and new competitors can enter our market with little difficulty and can launch new websites at a relatively low cost. We currently or potentially compete with a variety of other companies that sell baby, toddler and maternity products, including:
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traditional store-based retailers, such as Babies R Us, Baby Gap and USA Baby, and online efforts from these retailers such as BabiesRus.com;
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other online retailers, such as Babycenter.com and Babyage.com;
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major discount retailers such as Wal-Mart, Target and K-mart;
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catalog retailers;
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vendors that currently sell some of their products directly online;
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other online retailers that include baby, toddler and maternity products as part of their product offerings, such as Amazon.com; and
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Internet portals and online service providers that feature shopping services, such as AOL, Yahoo! and MSN.
We believe that the principal competitive factors in our market are product selection and quality, price, customer service and support, brand recognition, reputation, reliability and trust, web site features and functionality, convenience and delivery performance. We believe that we compare favorably in the online market for brand name baby products by offering detailed product information, broad product selection, competitive pricing and knowledgeable customer support to our customers.
Many of our traditional store-based and online competitors have longer operating histories, larger customer or user bases, greater brand recognition and significantly greater resources, particularly financial and marketing resources. Many of these competitors can devote substantially more resources to website development than we can. In addition, large, well-established and well-financed entities may join with online competitors in the future. Our competitors may be able to secure products from vendors on more favorable terms, offer popular products to which we do not have access, fulfill customer orders more efficiently and adopt more aggressive pricing or inventory availability policies than we can.
The baby, toddler and maternity product industries and the online commerce sector are highly competitive, dynamic in nature and have undergone significant changes over the past several years and will likely continue to undergo significant changes. Our ability to anticipate and respond successfully to these changes is critical to our long-term growth and we cannot assure you that we will anticipate and respond successfully to changes in the baby and toddler product industry and online commerce sectors. If we are unable to maintain our market share or compete effectively in the baby, toddler and maternity product market, our business, financial condition and operating results could be adversely affected.
Information Technology and Systems
We have used proprietary information technology systems for order fulfillment, merchandising and our e-commerce platform since our inception. We are continually improving the overall technology infrastructure to improve the shopping experience, order fulfillment capabilities and technical capacity. We successfully completed a system conversion project during 2005 to replace our accounting and financial reporting system with software provided by a major software vendor, as well as several projects to improve the security and reliability of our networks.
During 2006, we continued our technology improvements with two additional important projects. The first related to the implementation of a system to improve our warehouse management system, which coincided with the opening of our new distribution center in Las Vegas in January 2006. The second project related to the replacement of our proprietary e-commerce platform through an outsourcing contract with a major vendor. The conversion to an entirely outsourced e-commerce platform will be completed in stages throughout 2007.
Our information technology systems are currently, and will continue to be, hosted and backed up by third party providers. The facilities hosting our servers provide redundant heating, ventilation, air conditioning, power and Internet connectivity. The back-up facilities are in place to protect our operations in the event of hardware failure or facility failure and/or regional Internet or communications failures. In the event that our service providers experience a disruption in operations or cease operations for any reason, we will switch to back-up hosting facilities.
Our ability to receive and fulfill orders successfully through our websites is critical to our success and largely depends upon the efficient and uninterrupted operation of our computer and communications hardware and software systems, including the successful conversion of those systems that are undergoing replacement or upgrade. Our systems and operations are vulnerable to unanticipated difficulties encountered during system conversion, upgrade or replacement, as well as to damage or interruption from power outages, computer and telecommunications failures, computer viruses, security breaches, terrorist attacks, natural disasters and other catastrophic events, and errors in usage by our employees and customers. Any significant interruption in the availability or functionality of our websites, or our order processing, fulfillment, distribution or communications systems, for any reason could seriously harm our business.
Intellectual Property
We believe that our registered trademarks, “BabyUniverse.com”, “DreamtimeBaby.com”, “PoshTots.com” “PoshLiving.com”, “PoshCravings.com”, “ePregnancy.com” and “BabyTV.com”, and the brand name recognition that we have developed are of significant value. We strive to preserve the quality of our brand names and protect our trademarks and other intellectual property rights to ensure that the value of our proprietary rights is maintained. We rely on various intellectual property laws and contractual restrictions to protect our proprietary rights. These include copyright and trade secret laws and confidentiality, invention assignment and nondisclosure agreements with our employees, contractors, suppliers and strategic partners. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our intellectual property without our authorization. In addition, we pursue the registration of our trademarks and service marks in the U.S. and internationally. However, effective intellectual property protection may not be available in every country in which our products and services are made or will be made available online. For example, a company named Baby Universe based in New Zealand that uses the domain name babyuniverse.co.nz sells baby products via the Internet. If we are unable to protect or preserve the value of our intellectual property for any reason, our business would be harmed.
We also rely on technologies and products that we license from third parties. These licenses may not continue to be available to us on commercially reasonable terms, or at all, in the future. As a result, we may be required to develop or obtain substitute technology and products of lower quality and/or at greater cost, which could materially adversely affect our business, operating results and financial condition. Further, third parties may claim infringement by us with respect to our use of current or future technologies, whether developed by us or licensed from other parties. In addition, third parties may claim that the sale of one or more of our product offerings infringes their intellectual property rights. We expect that participants in our markets will be increasingly subject to infringement claims as the number of services and competitors in our industry segment grows. Any such claim, with or without merit, could be time consuming, result in costly litigation, cause service upgrade delays, cause us to discontinue use of a particular technology or the availability of a particular product offering, or require us to pay monetary damages or enter into royalty or licensing agreements. Such royalty or licensing agreements might not be available on terms acceptable to us or at all. As a result, any such claim of infringement against us could have a material adverse effect upon our business, operating results and financial condition.
Government Regulation
We are not currently subject to direct federal, state or local regulation other than regulations applicable to businesses generally or directly applicable to retailing or online commerce. However, as the Internet becomes increasingly popular, it is possible that a number of laws and regulations may be adopted with respect to the Internet. These laws may cover issues such as user privacy, freedom of expression, pricing, content and quality of products and services, taxation, advertising, intellectual property rights and information security. Further, the growth of online commerce may prompt calls for more stringent consumer protection laws. Several states have proposed legislation to limit the uses of personal user information gathered online or require online companies to establish privacy policies. The Federal Trade Commission has also initiated action against at least one online company regarding the manner in which personal information is collected from users and provided to third parties. The adoption of additional privacy or consumer protection laws could create uncertainty in Internet usage and reduce the demand for our products and services.
We are not certain how our business may be affected by the application of existing laws governing issues such as property ownership, copyrights, encryption and other intellectual property issues, taxation, libel, obscenity, qualification to do business and export or import matters. The vast majority of these laws were adopted prior to the advent of the Internet. As a result, they do not contemplate or address the unique issues of the Internet and related technologies. Changes in laws intended to address these issues could create uncertainty for those conducting online commerce. This uncertainty could reduce demand for our products and services or increase the cost of doing business as a result of litigation costs or increased fulfillment costs.
In addition, because our products and services are available over the Internet in multiple states, certain states may claim that we are required to qualify to do business in such state. Currently, we are qualified to do business in the states of Florida, Nevada and Virginia. Our failure to qualify to do business in a jurisdiction where we are required to do so could subject us to taxes and penalties. It could also hamper our ability to enforce contracts in these jurisdictions. The application of laws or regulations from jurisdictions whose laws do not currently apply to our business could harm our business and results of operations.
Employees
As of March 14, 2007, we had 87 full time employees, including 32 employees related to the PoshTots business acquired on January 13, 2006. Our employees are not party to any collective bargaining agreement, and we have never experienced an organized work stoppage. We believe our relations with our employees are good.
ITEM 1A.
ITEM 1A.
RISK FACTORS
Risks Related to Our Business
Our limited operating history makes it difficult for us to accurately forecast our revenues and appropriately plan our expenses.
We commenced operations in 1997 and have a limited operating history. As a result, it is difficult to accurately forecast our revenue and plan our operating expenses. We base our current and future expense levels on our operating forecasts and estimates of future revenues. Revenues and operating results are difficult to forecast because they generally depend on the volume and timing of the orders we receive, which are uncertain. Some of our expenses are fixed and, as a result, we may be unable to adjust our spending in a timely manner to compensate for any unexpected shortfall in revenues. This inability could cause our net income in a given quarter to be lower, or our net loss in a given quarter to be higher, than expected.
We have incurred significant operating losses in the past and may not be able to sustain profitability in the future.
We experienced significant operating losses from our commencement of operations and were not profitable on a full year basis except for 2004. As a result, our business has a limited record of profitability and may not become profitable or increase in profitability. If we are unable to acquire baby, toddler and maternity products at commercially reasonable prices, if revenues decline or if our expenses otherwise exceed our expectations, we may not be able to sustain or increase profitability on a quarterly or annual basis.
As a result of our significant operating losses in prior periods, we have accrued substantial net operating loss carryforwards. If we are unsuccessful in generating sufficient net income in future periods, these assets may expire before they are utilized.
We have significant working capital needs and if we are unable to obtain additional financing, when needed, we may not have sufficient cash flow to run our business.
As of December 31, 2006, our cash on hand amounted to just over $3.47 million. While we intend to finance our future operations from our cash balance and from cash flow from operations, these sources may not provide us with adequate financing. In that event, we would need to seek additional financing from lenders and investors. If we are not able to obtain such adequate financing, when needed, it would have a material adverse effect on our financial condition and results of operations.
The terms of our indebtedness may restrict our ability to operate and grow our business.
The terms of our Senior Loan and Security Agreement with Hercules Technology Capital, Inc. (the “Loan” or the “Loan Agreement”) impose restrictions on our ability to, among other things, borrow and make investments, acquire other businesses, and make capital expenditures and distributions on our capital stock. In addition, the Loan Agreement requires us to satisfy specified financial covenants, including a covenant to maintain a current ratio of at least .90 on December 31, 2006 and at least 1.0 thereafter. Our ability to comply with these provisions depends, in part, on factors over which we may not have control. These restrictions could adversely affect our ability to pursue our operating and growth strategy. If we fail to maintain the required current ratio, we have certain rights to cure such failure with an equity financing, but there can be no assurance that we would be able to raise such equity financing to effectuate such a cure. If we were to breach any of our financial covenants with our creditors or fail to make scheduled payments, and such breach continues beyond applicable cure periods, such creditors could declare all amounts owed to them to be immediately due and payable. We may not have available funds sufficient to repay the amounts declared due and payable and may have to sell our assets to repay those amounts. The Loan is secured by substantially all of our assets. If we cannot repay all amounts that we have borrowed under the Loan Agreement, the lender thereunder could proceed against our assets.
Our quarterly operating results may fluctuate and could be below expectations because we operate in the retail sales industry, which is seasonal.
We operate in the retail sales industry, which is seasonal and dependent on general economic conditions, consumer spending and other factors. Our historical results of operations have been moderately seasonal, reflecting a general pattern of peak sales in mid-fourth quarter. We believe that our limited operating history and historical growth trends may have masked the effect of typical seasonal fluctuations. We cannot assure you that our business will continue its historical growth trend, or that it will not conform to industry norms for seasonality in future periods. Companies operating in the retail sales industry typically realize a disproportionate amount of their revenues during the fourth quarter of each calendar year. If our business begins to reflect industry norms for seasonality, we may incur significant additional expenses during our fourth quarter, including higher inventory of product and additional staffing in our fulfillment and customer support operations, in anticipation of increased sales activity. Consequently, if we were to experience lower than expected revenues during any future fourth quarter, whether from a general decline in economic conditions or other factors beyond our control, it would have a disproportionately large impact on our operating results and financial condition for that year. In the future, our seasonal sales patterns may become more pronounced, may strain our personnel and fulfillment activities and may cause a shortfall in revenues as compared to expenses in a given period, which would substantially harm our financial condition and results of operations.
Purchasers of baby, toddler and maternity products may not choose to shop online, which would prevent us from increasing revenues.
The online market for baby, toddler and maternity products is significantly less developed than the online market for books, music and other consumer products. If this market does not gain widespread acceptance, our business may suffer. Our success will depend in part on our ability to attract consumers who have historically purchased baby, toddler and maternity products through traditional retailers. Furthermore, we may have to incur significantly higher and more sustained advertising and promotional expenditures or price our products more competitively than we currently anticipate, in order to attract additional online consumers to our websites and convert them into purchasing customers. Specific factors that could dissuade consumers from purchasing baby, toddler and maternity products from us include:
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concerns about buying baby, toddler and maternity products such as luxury strollers, expensive car seats and bedding for their child without a physical storefront, face-to-face interaction with sales personnel and the ability to physically handle and examine products;
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delivery time and/or costs associated with Internet orders;
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product offerings that do not reflect consumer tastes and preferences;
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pricing that does not meet consumer expectations;
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concerns about the security of online transactions and the privacy of personal information;
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delayed shipments or shipments of incorrect or damaged products; and
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inconvenience associated with returning or exchanging purchased items.
We intend to undertake acquisitions to expand our business, which may pose risks to our business and dilute the ownership of our existing shareholders.
A key component of our business strategy includes strengthening our competitive position and refining the customer experience on our websites through internal development and growth. However, we intend to selectively pursue strategic acquisitions of companies in our industry. Integrating any newly acquired companies may be expensive and time-consuming. To finance any acquisition, it may be necessary for us to raise additional funds through public or private financings.
Additional funds may not be available on terms that are favorable to us, and, in the case of equity financings, would result in dilution to our shareholders. Any such acquisition may involve a number of risks, including:
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Financial risks, such as (1) potential liabilities of the acquired company; (2) costs associated with integrating acquired operations and businesses; (3) the dilutive effect of the issuance of additional equity securities; (4) the incurrence of debt; (5) the financial impact of valuing goodwill and other intangible assets involved in any acquisitions, potential future impairment write-downs of goodwill and the amortization of other intangible assets; (6) possible adverse tax and accounting effects; and (7) overpayment for the company.
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Operating risks, such as (1) the diversion of management’s attention to the integration of the businesses to be acquired; (2) the risk that the acquired businesses will fail to maintain the quality of services that we have historically provided; (3) the need to implement financial and other systems and add management resources; (4) the risk that key employees of the acquired businesses will leave after the acquisition; and (5) unforeseen difficulties in the acquired operations.
We cannot assure you that we will be able to consummate any acquisitions or, if consummated, successfully integrate the operations and management of future acquisitions. If we are unable to attract and consummate acquisitions, our growth could be adversely impacted.
We may not succeed in continuing to establish our brands, which would prevent us from acquiring customers and increasing our revenues.
Since we have a limited operating history, a significant component of our business strategy is the continued establishment and promotion of the BabyUniverse, DreamtimeBaby, PoshTots, PoshLiving, PoshCravings ePregnancy and BabyTV brands. Due to the highly-fragmented and competitive nature of the online market for baby, toddler and maternity products, if we do not continue to establish our brands, we may fail to build the critical mass of customers required to substantially increase our revenues. Promoting and positioning our brands will depend largely on the success of our marketing and merchandising efforts and our ability to provide consistent, high quality customer experiences. To promote our brands, we have incurred and will continue to incur substantial expenses related to advertising, public relations and other marketing efforts. The failure of our brand promotion activities could adversely affect our ability to attract new customers and maintain customer relationships, and, as a result, substantially harm our financial condition and results of operations.
We face significant competition and may be unsuccessful in competing against current and future competitors.
The baby, toddler and maternity products retail industry is intensely competitive, and we expect competition in the market to increase and intensify in the future. Increased competition may result in price pressure, reduced gross margins and loss of market share, any of which could substantially harm our financial condition and results of operations. Current and potential competitors include:
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traditional store-based retailers, such as Babies R Us, Baby Gap and USA Baby, and online efforts from these retailers such as BabiesRus.com;
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other online retailers, such as Babycenter.com and Babyage.com;
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major discount retailers such as Wal-Mart, Target and K-mart;
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catalog retailers;
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vendors that currently sell some of their products directly online;
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other online retailers that include baby, toddler and maternity products as part of their product offerings, such as Amazon.com; and
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Internet portals and online service providers that feature shopping services, such as AOL, Yahoo! and MSN.
Many of our current and potential competitors have advantages over us, including longer operating histories, greater brand recognition, more extensive customer and supplier relationships, and significantly greater financial, marketing and other resources. In addition, traditional store-based retailers offer consumers the ability to physically handle and examine products in a manner that is not possible over the Internet, as well as a more convenient means of returning and exchanging purchased products.
Some of our competitors seeking to establish an online presence may be able to devote substantially more resources to website systems development and exert more leverage over the supply chain for baby, toddler and maternity products than we can. In addition, larger, more established and better capitalized entities may acquire, invest in or partner with traditional and online competitors as use of the Internet and other online services increases. Our online competitors can duplicate many of the products, services and content we offer, which could harm our financial condition and results of operations.
In order to increase revenues and to sustain or increase profitability, we must attract customers in a cost-effective manner.
Our success depends on our ability to attract customers in a cost-effective manner. We have relationships with providers of online services, search engines, directories and other websites and e-commerce businesses to provide content, advertising banners and other links that direct customers to our websites. We rely on these relationships as significant sources of traffic to our websites. Our agreements with these providers generally have terms of one year or less. If we are unable to develop or maintain these relationships on acceptable terms, our ability to attract new customers would be harmed. In addition, many of the parties with which we have online-advertising arrangements could provide advertising services to other online or traditional retailers, including retailers with whom we compete. As a result, these parties may be reluctant to enter into or maintain relationships with us. Without these relationships, traffic to our websites could be reduced, which would substantially harm our financial condition and results of operations.
The shopping comparison portals on which we list our products (and through which we currently generate a significant percentage of our customer orders) may alter the terms of their merchant agreements at will, exposing us to a number of risks, including higher fees and an increased challenge of gaining prominent placement of our products on these portals.
By virtue of the listing of our products on the various shopping comparison portals through which we currently generate a significant percentage of our customer orders, we are subject to the terms and conditions of such portals’ merchant and similar agreements. These agreements differ from one shopping comparison portal to another, but, in general, they provide that the comparison shopping portals can freely alter the terms and conditions of such agreements.
This exposes us to a number of potential risks, including the risk that any or all of these portals may:
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implement policies that prohibit our multiple website marketing strategy;
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given their relative bargaining power as compared to listing merchants such as us, raise the minimum fees that some of these portals impose; and
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alter the bases for a merchant’s initial or default listing on certain of these portals, which currently are dependent on such variables as the product price points or the quality of the merchant’s customer review ratings.
Changes in the terms and conditions of our merchant and similar agreements with the shopping comparison portals on which we list our products could change or limit our marketing strategies, which may, in turn, disadvantage us relative to our competitors, particularly those with greater financial resources, increase our operating expenses and otherwise harm our business.
Our failure to meet customer expectations with respect to price would adversely affect our financial condition and results of operations.
Demand for our products has been highly sensitive to pricing changes. In fact, we believe that a significant percentage of our online shoppers are greatly motivated by price. While we maintain manufacturer’s suggested retail pricing for some popular products, certain of our competitors may discount products below these levels. We may, therefore, be forced to lower prices for certain products. Any such changes in our pricing strategies have had and may continue to have a significant impact on our revenues, gross margins and net income or net loss. If we fail to meet customer expectations with respect to price in any given period, our revenues may be negatively impacted and our financial condition and results of operations would suffer.
We rely primarily on the sale of baby, toddler and maternity products for our revenues, and demand for these products could decline.
The volume and dollar value of purchases of baby, toddler and maternity products, such as strollers, car seats and bedding, may significantly decrease during economic downturns. The success of our business depends in part on macroeconomic factors such as employment levels, salary levels, tax rates and credit availability, all of which affect consumer spending and disposable income. Any reduction in consumer spending or disposable income may affect us more significantly than companies in other industries.
Our revenues and results of operations are, in part, dependent on the demand for strollers, car seats and bedding. Should prevailing consumer tastes for these products decline, demand for our products would decline and our business and results of operations would be substantially harmed.
Our brands and reputation and our ability to increase revenues may depend on our ability to successfully expand our product offerings.
Our ability to significantly increase our revenues and maintain and increase our profitability may depend on our ability to successfully expand our product lines and our targeted product end user age group beyond our current offerings. Specifically, we intend to expand our product offerings in the toddler and maternity markets. If we offer a new product category that is not accepted by consumers or if we offer a series of products that are recalled for safety reasons, our brands and reputation could be adversely affected, our revenues may fall short of expectations and we may incur substantial expenses that are not offset by increased revenues. Expansion of our product lines may also strain our management and operational resources.
If we decide to offer new product lines or categories, we may jeopardize our current reputation and experience a decline in our operating results.
We currently generate substantially all of our revenue from the sale of baby products. If we decide to commence offering new product lines or categories, our internal sales and delivery processes may not prove effective with respect to such other product categories. In addition, expansion into new product lines or categories may require us to incur significant marketing expenses and capital investments, develop sourcing arrangements with new vendors and comply with additional regulatory requirements. These requirements could strain our managerial, financial and operational resources. Additional challenges that may affect our ability to expand into new product categories include our ability to:
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attract and retain suppliers to provide the expanded line of products to our customers on terms that are acceptable to us;
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establish or increase awareness of new brands and product categories;
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successfully market these new product offerings to existing and new customers;
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achieve and maintain a critical mass of customers and orders across these product categories; and
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maintain quality control over merchandise drop shipped directly by our suppliers to our customers.
We may not be able to successfully address any or all of these challenges. This could hamper a component of our growth strategy, damage our reputation in the eyes of our existing customers or suppliers, and cause a decline in our results of operations.
If our fulfillment operations are interrupted for any significant period of time, our reputation and brand could be damaged and our financial condition and results of operations would be substantially harmed.
Our success depends on our ability to successfully receive and fulfill orders and to promptly and securely deliver our products to our customers. A portion of our inventory management, packaging, labeling and product return processes are performed from multiple facilities operated by other companies. Our newly opened Las Vegas fulfillment center is susceptible to damage or interruption from human error, fire, flood, power loss, telecommunications failure, terrorist attacks, acts of war, break-ins, earthquakes and similar events. We do not currently maintain back-up power systems at our Las Vegas fulfillment center. Our insurance may be insufficient to compensate us for losses that may occur in the event operations at our fulfillment center or a fulfillment center of one of our fulfillment vendors is interrupted. We may transfer or expand our fulfillment operations to a larger fulfillment center, or multiple fulfillment centers, in the future. Any interruptions in our fulfillment center operations for any significant period of time, including interruptions resulting from the transfer to a new facility or the conversion to newly developed warehouse management systems, could damage our reputation and brand and substantially harm our financial condition and results of operations.
Our failure to acquire inventory at commercially reasonable prices would result in higher costs and lower gross margins and damage our competitive position.
We purchase products for resale either directly from manufacturers, via drop ship arrangements or through our newly opened Las Vegas distribution center, or, to a lesser degree, through our California fulfillment agent. If we are unable to acquire inventory at commercially reasonable prices, our costs may exceed our forecasts, our gross margins and operating results may suffer and our competitive position could be damaged. The success of our business model depends, in part, on our ability to offer prices to customers that are at or below those of traditional baby retailers. We do not have supply agreements with our suppliers or such agreements are cancelable upon 30 -days notice, and therefore, they can stop supplying us products at any time, for no reason and with limited or no notice. Our inability to maintain and expand these and other inventory supply relationships on commercially reasonable terms or the inability of our current and future suppliers to maintain arrangements for the supply of products sold to us on commercially reasonable terms would substantially harm our financial condition and results of operations.
If we fail to successfully expand our fulfillment capabilities, we may not be able to increase our revenues.
We fulfill approximately 39% of our orders through our leased Las Vegas fulfillment center and a third party warehouse and fulfillment center in St. Louis. We therefore rely extensively on other companies to fulfill our orders. If we or our vendors fail to quickly and efficiently fill customer orders, our operating results may suffer. The increased demand and other considerations may require us to significantly expand our fulfillment capabilities and facilities in the future. If we or our vendors do not successfully expand our or their fulfillment capabilities to accommodate increases in demand, we may not be able to substantially increase our revenues. Our efforts at expanding our fulfillment capabilities may cause disruptions in other areas of our business which could substantially harm our business and results of operations.
We rely on our suppliers and third-party carriers as a large part of our fulfillment process, and these third parties may fail to adequately serve our customers.
In general, we extensively rely on our suppliers to promptly ship products to us or directly to our customers. Any failure by our suppliers to sell and ship such products to us or our customers will have an adverse effect on our ability to fulfill customer orders and harm our business and results of operations. Our suppliers, in turn, rely on third-party shippers to ship products to us or directly to the customers. We also rely on third-party shippers for product shipments to our customers. We are therefore subject to the risks, including employee strikes and inclement weather, associated with such carriers’ abilities to provide delivery services to meet our and our suppliers’ shipping needs. Our suppliers’ and third-party carriers’ failure to deliver products to us or our customers in a timely manner or to otherwise adequately serve our customers would damage our reputation and brand and substantially harm our financial condition and results of operations.
If we are unable to accurately manage our inventory, our costs of goods sold may increase more than expected and our reputation, financial condition and results of operations could suffer.
While we have historically maintained low levels of inventory, we have recently begun to increase the levels of inventory we carry. Therefore, changes in consumer tastes for our products will subject us to increased inventory risks. The demand for specific products can change between the time we order an item and the date we receive it. Also, if we, our drop shippers or our fulfillment partner under-stock one or more of our products, we may not be able to obtain additional units in a timely manner on terms favorable to us, if at all, which would damage our reputation and substantially harm our business and results of operations. In addition, if demand for our products increases over time, we may be forced to increase inventory levels. If one or more of our products does not achieve widespread consumer acceptance, we may be required to take significant inventory markdowns, or may not be able to sell the product at all, which would substantially harm our financial condition and results of operations.
Our failure to effectively manage the growth in our operations may prevent us from successfully expanding our business.
We have experienced, and in the future may experience, rapid growth in operations, which has placed, and could continue to place, a significant strain on our operations, services, internal controls and other managerial, operational and financial resources. To effectively manage future expansion, we will need to maintain and/or expand our operational and financial systems and managerial controls and procedures, which include the following processes:
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transaction-processing and fulfillment;
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inventory management;
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customer support;
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management of multiple supplier relationships;
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operational, financial and managerial controls;
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reporting procedures; and
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training, supervision, retention and management of our employees.
If we are unable to manage future expansion, our ability to provide a high quality customer experience could be harmed, which would damage our reputation and brand and substantially harm our financial condition and results of operations.
Any significant interruption in the availability or functionality of our websites, or our order processing, fulfillment, distribution or communications systems, for any reason could seriously harm our business.
We have used proprietary information technology systems for order fulfillment, merchandising and our e-commerce platform since our inception. We are continually improving the overall technology infrastructure to improve the shopping experience, order fulfillment capabilities and technical capacity. In that regard, we successfully completed a system conversion project during 2005 to replace our accounting and financial reporting system with software provided by a major software vendor, as well as several projects to improve the security and reliability of our networks.
During 2006, we continued our technology improvements with two additional important projects. The first related to the implementation of a system to improve our warehouse management system, which coincided with the opening of our new distribution center in Las Vegas in January 2006. The second project related to the replacement of our proprietary e-commerce platform through an outsourcing contract with a major vendor. The conversion to an entirely outsourced e-commerce platform will be completed in stages throughout 2007.
Our ability to receive and fulfill orders successfully through our websites is critical to our success and largely depends upon the efficient and uninterrupted operation of our computer and communications hardware and software systems, including the successful conversion of those systems that are undergoing replacement or upgrade. Our systems and operations are vulnerable to unanticipated difficulties encountered during system conversion, upgrade or replacement, as well as to damage or interruption from power outages, computer and telecommunications failures, computer viruses, security breaches, terrorist attacks, natural disasters and other catastrophic events, and errors in usage by our employees and customers. Any significant interruption in the availability or functionality of our websites, or our order processing, fulfillment, distribution or communications systems, for any reason could seriously harm our business.
If the hosting facilities where substantially all of our computer and communications hardware is located fail, our ability to effectively conduct business would be harmed.
Our ability to successfully receive and fulfill orders and to provide high quality customer service depends in part on the efficient and uninterrupted operation of our computer and communications systems. Our systems and operations are vulnerable to damage or interruption from human error, fire, flood, power loss, telecommunications failure, terrorist attacks, acts of war, break-ins and similar events. We do not presently have entirely redundant systems in multiple locations and our business interruption insurance may be insufficient to compensate us for losses that may occur. In addition, our servers are vulnerable to computer viruses, physical or electronic break-ins and similar disruptions, which could lead to interruptions, delays, loss of critical data, the inability to accept and fulfill customer orders or the unauthorized disclosure of confidential customer data. The occurrence of any of the foregoing risks could substantially harm our financial condition and results of operations.
We rely on the services of our key personnel, any of whom would be difficult to replace.
We rely upon the continued service and performance of key technical, fulfillment and senior management personnel. If we lose any of these personnel, our business could suffer. Our future success depends on our retention of key employees, including John C. Textor, our Chairman of the Board and Chief Executive Officer, and Jonathan Teaford, Executive Vice President, both of whom we rely on for management of our company, development of our business strategy and management of our strategic relationships. Executive officers of the Company are bound by employment and noncompetition agreements. However, many of our other key technical, fulfillment or management personnel are not bound by employment or noncompetition agreements, and, as a result, these employees could leave with little or no prior notice.
Failure to adequately protect our intellectual property could damage our reputation and brands and substantially harm our business, financial condition and results of operations.
Our success depends to a significant extent upon the protection of our proprietary intellectual property rights. We rely on a combination of trademarks, trade secrets, copyright law and contractual restrictions to protect our intellectual property. These afford only limited protection. Despite our efforts to protect and enforce our proprietary rights, unauthorized parties may attempt to copy aspects of our website features and functionality or to obtain and use information that we consider as proprietary, such as the technology used to operate our websites, our content and our trademarks.
We have registered “BabyUniverse.com”, “DreamtimeBaby.com”, “PoshTots.com”, “PoshLiving.com”, “PoshCravings.com”, “ePregnancy.com” and “BabyTV.com”, and the related logos as trademarks in the U.S. and Canada. We have also applied for the registration of our logos in their current formats in the United States and expect to continue to pursue the registration of our key service marks in relevant jurisdictions from time to time. There can be no assurance that any of these applications will be approved, that any issued registration will protect our intellectual property or that third parties will not challenge our marks. In addition, it is possible that trademark protection may not be available or may not be sought in every country in which our services are made available online.
Our competitors have, and other competitors may, adopt service names similar to ours, thereby impeding our ability to build brand identity and possibly leading to customer confusion. In addition, there could be potential infringement claims brought by owners of other registered trademarks that incorporate variations of our trademarks or servicemarks. Any claims or customer confusion related to our trademarks or service marks could damage our reputation and brands and substantially harm our business, financial condition and results of operations.
We currently hold several Internet domain names. Domain names generally are regulated by Internet regulatory bodies. We have not registered any country-specific domain names. If we lose the ability to use a domain name in a particular country, we would be forced to either incur significant additional expenses to market our products within that country, including the development of a new brand and the creation of new promotional materials and packaging, or elect not to sell products in that country. Either result could substantially harm our business and results of operations. The regulation of domain names in the United States and in foreign countries is subject to change. Regulatory bodies could establish additional top-level domains, appoint additional domain name registrars or modify the requirements for holding domain names. As a result, we may not be able to acquire or maintain relevant domain names in all of the countries in which we currently or intend to conduct business.
The domain name babyuniverse.co.nz is registered and owned by a company named Baby Universe based in New Zealand. We are not related to or affiliated with the New Zealand company. The New Zealand company sells baby products via the Internet and appears to be focused substantially on the markets of Australia and New Zealand, as it claims on its website that many of its overseas customers place orders for friends and relatives living in Australia and New Zealand. The New Zealand company also claims it can ship to and has customers located in the United States, Canada and other countries where we conduct or intend to conduct business in the future. We have advised the New Zealand website to cease and desist from shipping goods into the United States. Our inability to successfully assert the priority of our rights in the BabyUniverse or our other names, trademarks and brands in the United States or other countries could harm our business and results of operations.
Litigation or proceedings before the U.S. Patent and Trademark Office may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets and domain names and to determine the validity and scope of the proprietary rights of others. Any litigation or adverse priority proceeding could result in substantial costs and diversion of resources and could substantially harm our business and results of operations. Finally, we intend to sell our products internationally, and the laws of many countries do not protect our proprietary rights to as great an extent as do the laws of the United States.
Assertions by third parties of infringement by us of their intellectual property rights could result in significant costs and substantially harm our business and results of operations.
Other parties may assert infringement or unfair competition claims against us. In the past, we have received notices from third parties alleging that our service marks infringe proprietary rights held by them. We may receive other similar notices from, or have lawsuits filed against us by, third parties in the future. We cannot predict whether third parties will assert claims of infringement against us, or whether any past, present or future claims will prevent us from operating our business as planned or whether any such assertions or claims arising from such assertions will substantially harm our business and results of operations. If we are forced to defend against any infringement claims, whether they are with or without merit or are determined in our favor, we may face costly litigation, diversion of technical and management personnel or product shipment delays. Furthermore, the outcome of a dispute may be that we would need to develop non-infringing technology or enter into royalty or licensing agreements. Royalty or licensing agreements, if required, may not be available on terms acceptable to us, or at all.
Increased product returns and the failure to accurately predict product returns could substantially harm our business and results of operations.
We offer our customers 30 day return policies that allow our customers to return most products (except special order items that are subject to a 30% restocking fee) if they are not satisfied with their purchase for any reason. Actual merchandise returns are difficult to predict and may significantly exceed our projections or our expectations. Any significant increase in merchandise returns above our allowances would substantially harm our business, financial condition and results of operations.
We may be unsuccessful in expanding our operations internationally.
To date, we have made very limited international sales, but we anticipate expanding our international sales in the long term. Any international expansion plans we choose to undertake will require management attention and resources and may be unsuccessful. We have minimal experience in selling our products in international markets or in conforming to the local cultures, standards or policies necessary to successfully compete in those markets. We do not currently have any international fulfillment, distribution or server facilities or any website content localized for foreign markets and we cannot be certain that we will be able to establish a global presence if we choose to expand internationally. In addition, we may have to compete with retailers that have more experience with local markets. Our ability to expand internationally may also be limited by the demand for our products and the adoption of e-commerce in these markets. Different privacy, censorship and liability standards and regulations and different intellectual property laws in foreign countries may cause our financial condition and results of operations to suffer.
Any future international operations may also fail to succeed due to other risks inherent in foreign operations, including:
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the need to develop new supplier and shipper relationships;
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unexpected changes in international regulatory requirements and tariffs;
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higher costs, and longer delivery times, associated with international shipping;
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difficulties in staffing and managing foreign operations;
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longer payment cycles from credit card companies;
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potential adverse tax consequences;
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lack of infrastructure to adequately conduct e-commerce transactions or fulfillment operations;
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the inability to use our various brand names or trademarks;
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price controls or other restrictions on or fluctuations in foreign currency; and
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difficulties in obtaining export and import licenses.
Our failure to successfully expand our operations internationally may cause our financial condition and results of operations to suffer.
Risks Related to Our Industry
If use of the Internet, particularly with respect to online commerce, does not continue to increase as rapidly as we anticipate, our business will be harmed.
Our future revenues and profits are substantially dependent upon the continued use of the Internet as an effective medium of business and communication by our target customers. Internet use may not continue to develop at historical rates and consumers may not continue to use the Internet and other online services as a medium for commerce. Highly publicized failures by some online retailers to meet consumer demands could result in consumer reluctance to adopt the Internet as a means for commerce, and thereby damage our reputation and brand and substantially harm our financial condition and results of operations.
In addition, the Internet may not be accepted as a viable long-term commercial marketplace for a number of reasons, including:
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the need to develop new supplier and shipper relationships;
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actual or perceived lack of security of information or privacy protection;
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possible disruptions, computer viruses or other damage to the Internet servers or to users’ computers; and
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excessive governmental regulation.
Our success will depend, in large part, upon third parties maintaining the Internet infrastructure to provide a reliable network backbone with the speed, data capacity, security and hardware necessary for reliable Internet access and services. Our business, which relies on contextually rich websites that require the transmission of substantial data, is also significantly dependent upon the availability and adoption of broadband Internet access and other high speed Internet connectivity technologies.
Our revenues may be negatively affected if we are required to charge taxes on purchases.
We do not collect or have imposed upon us sales or other taxes related to the products we sell, except for certain corporate level taxes and sales taxes with respect to purchases shipped to customers located in the states of Florida, Nevada and Virginia. However, one or more states or foreign countries may seek to impose sales or other tax collection obligations on us in the future. A successful assertion by one or more states or foreign countries that we should be collecting sales or other taxes on the sale of our products could result in substantial tax liabilities for past sales, discourage customers from purchasing products from us, decrease our ability to compete with traditional retailers or otherwise substantially harm our financial condition and results of operations.
Currently, decisions of the U.S. . Supreme Court restrict the imposition of obligations to collect state and local sales and use taxes with respect to sales made over the Internet. However, implementation of the restrictions imposed by these Supreme Court decisions is subject to interpretation by state and local taxing authorities. While we believe that these Supreme Court decisions currently restrict state and local taxing authorities outside the states of Florida, Nevada and Virginia from requiring us to collect sales and use taxes from purchasers located within their jurisdictions, taxing authorities outside the states of Florida, Nevada and Virginia could disagree with our interpretation of these decisions. Moreover, a number of states, as well as the U.S. Congress, have been considering various initiatives that could limit or supersede the Supreme Court’s position regarding sales and use taxes on Internet sales. If any state or local taxing jurisdiction were to disagree with our interpretation of the Supreme Court’s current position regarding state and local taxation of Internet sales, or if any of these initiatives were to address the Supreme Court’s constitutional concerns and result in a reversal of its current position, we could be required to collect sales and use taxes from purchasers located in states other than Florida, Nevada and Virginia. The imposition by state and local governments of various taxes upon Internet commerce could create administrative burdens for us and could decrease our future revenues.
Government regulation of the Internet and e-commerce is evolving and unfavorable changes could substantially restrict our ability to do business and harm our financial condition and results of operations.
We are subject to general business regulations and laws as well as regulations and laws specifically governing the Internet and e-commerce. Existing and future laws and regulations may impede the growth of the Internet or other online services. These regulations and laws may cover taxation, restrictions on imports and exports, customs, tariffs, user privacy, data protection, pricing, content, copyrights, distribution, electronic contracts and other communications, consumer protection, the provision of online payment services, broadband residential Internet access and the characteristics and quality of products and services. It is not clear how existing laws governing issues such as property ownership, sales and other taxes, libel and personal privacy apply to the Internet and e-commerce. Unfavorable resolution of these issues may substantially harm our financial condition and results of operations.
Our failure to protect confidential information of our customers and our network against security breaches could damage our reputation and brand and substantially harm our financial condition and results of operations.
A significant predicate for online commerce and communications is customer confidence in the secure transmission of confidential information over public networks, and a failure to prevent security breaches could damage our reputation and brand and substantially harm our business and results of operations. Currently, a significant number of our customers authorize us to bill their credit card accounts directly. We rely on encryption and authentication technology licensed from third parties to effect secure transmission of confidential information, including credit card numbers. Advances in computer capabilities, new discoveries in the field of cryptography or other developments may result in a compromise or breach of the technology used by us to protect customer transaction data.
Any such compromise of our security could damage our reputation and brands and expose us to a risk of loss or litigation and possible liability which would substantially harm our business and results of operations. In addition, anyone who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions in our operations. We may need to expend significant resources to protect against security breaches or to address problems caused by breaches.
Interruptions to our systems that impair customer access to our websites would damage our reputation and brands and substantially harm our financial condition and results of operations.
The satisfactory performance, reliability and availability of our websites, transaction processing systems and network infrastructure are critical to our reputation and our ability to attract and retain customers and to maintain adequate customer service levels. Any future systems interruption that results in the unavailability of our websites or reduced order fulfillment performance could result in negative publicity, damage our reputation and brands and cause our business and results of operations to suffer. Although we have not experienced any material disruption in our services to date, we may be susceptible to such disruptions in the future. We may also experience temporary system interruptions for a variety of other reasons in the future, including power failures, software errors or an overwhelming number of visitors trying to reach our websites during periods of strong demand or promotions. Because we are dependent in part on third parties for the implementation and maintenance of certain aspects of our systems, and because some of the causes of system interruptions may be outside of our control, we may not be able to remedy such interruptions in a timely manner, or at all.
Our failure to address risks associated with credit card fraud could damage our reputation and brands and may cause our financial condition and results of operations to suffer.
Under current credit card practices, we are liable for fraudulent credit card transactions because we do not obtain a cardholder’s signature. We do not currently carry insurance against this risk. To date, we have experienced minimal losses from credit card fraud, but we face the risk of significant losses from this type of fraud as our revenues increase. Our failure to adequately control fraudulent credit card transactions could damage our reputation and brands and substantially harm our financial condition and results of operations.
Our failure to rapidly respond to technological change could result in our services or systems becoming obsolete and substantially harm our financial condition and results of operations.
As the Internet and online commerce industries evolve, we may be required to license emerging technologies useful in our business, enhance our existing services, develop new services and technologies that address the increasingly sophisticated and varied needs of our prospective customers and respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis. We may not be able to successfully implement new technologies or adapt our websites, proprietary technologies and transaction-processing systems to customer requirements or emerging industry standards. Our failure to do so would substantially harm our financial condition and results of operations.
Risks Related to Our Common Stock
The market price of our common stock may experience substantial fluctuations for reasons over which we have little control.
Our common stock is traded on The Nasdaq Capital Market. The stock price and the share trading volume for companies in the retail sales industry is subject to significant volatility. Both company-specific and industry-wide developments, as well as changes to the overall condition of the US economy and stock market, may cause this volatility. The market price of our common stock could fluctuate up or down substantially based on a variety of factors, including the following:
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future announcements concerning us, our competitors, and the companies with whom we have relationships or the online market for baby, toddler and maternity products;
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changes in operating results from quarter to quarter;
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sales of stock by insiders;
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changes in government regulations;
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changes in estimates by analysts;
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news reports relating to trends in our markets;
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the seasonal nature of the retail sales industry;
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acquisitions and financings in our industry; and
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the overall volatility of the stock market.
Furthermore, stock prices for many companies fluctuate widely for reasons that may be unrelated to their operating results. These fluctuations, coupled with changes in our results of operations and general economic, political and market conditions, may adversely affect the market price of our common stock.
Our single largest shareholder and our management team collectively own approximately 47.0% of our common stock and may be able to exercise significant influence over the outcome of matters to be voted on by our shareholders.
As of March 20, 2007, John C. Textor, the other members of our management team, and certain of Mr. Textor’s affiliates that he controls, together beneficially owned approximately 47.0% of the outstanding shares of our common stock. Mr. Textor is the Chairman of our Board of Directors and our Chief Executive Officer. Accordingly, Mr. Textor, together with the other members of our management team, may be able to exercise significant influence with respect to the election of directors, offers to acquire us and other matters submitted to a vote of our shareholders.
Risks Related to Our Proposed Merger with eToys Direct
Failure to complete the Merger may result in our obligation to pay a termination fee to eToys Direct and could harm our common stock price and future business and operations.
If the merger with eToys Direct is not completed, we may be subject to the following risks:
•
if the Merger Agreement is terminated under certain circumstances, we will be required to pay eToys Direct a termination fee of $1,567,178, and reimburse eToys Direct for the expenses incurred by it in connection with the transaction in a maximum amount of $1,500,000;
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the price of our common stock may decline; and
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costs incurred by us related to the Merger, such as legal, accounting and certain financial advisory fees, must be paid by us even if the Merger is not completed.
In addition, if the Merger Agreement is terminated and our Board of Directors determines to seek another business combination, there can be no assurance that we will be able to find a partner willing to provide equivalent or more attractive consideration than the consideration to be provided in the Merger.
The market price of our common stock may decline as a result of a completed merger with eToys Direct.
The market price of our common stock may decline as a result of the Merger for a number of reasons including if:
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the combined company does not achieve the perceived benefits of the Merger as rapidly or to the extent anticipated by financial or industry analysts;
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the effect of the Merger on the combined company’s business and prospects is not consistent with the expectations of financial or industry analysts; or
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investors react negatively to the effect on the combined company’s business and prospects of the Merger.
Our shareholders may not realize a benefit from the Merger commensurate with the ownership dilution they will experience in connection with the Merger.
If the combined company is unable to realize the strategic and financial benefits currently anticipated from the Merger, our shareholders will have experienced substantial dilution of their ownership interest without receiving a commensurate benefit.
During the pendency of the Merger, we may not be able to enter into a business combination with another party at a favorable price because of restrictions in the Merger Agreement.
Covenants in the Merger Agreement impede our ability to make acquisitions or complete other transactions that are not in the ordinary course of business pending completion of the Merger. As a result, if the Merger is not completed, we may be at a disadvantage to our competitors as a result of these foregone opportunities. In addition, while the Merger Agreement is in effect, subject to very narrowly defined exceptions, we are prohibited from soliciting, initiating, encouraging or entering into certain extraordinary transactions, such as a merger, sale of assets or other business combination outside the ordinary course of business, with any third party.
If we do not successfully integrate our and eToys Direct’s business operations following a consummation of the Merger, the anticipated benefits of the Merger may not be fully realized or may not occur for an extended period of time.
If we do not successfully integrate the two companies upon completion of the Merger, the anticipated benefits of the Merger may not be fully realized or may not occur for an extended period of time. No assurance can be given that we will be able to integrate the two companies’ operations without encountering difficulties, including, without limitation, the loss of key employees and customers, the disruption of respective ongoing businesses or possible inconsistencies in standards, controls, procedures and policies. Successful integration of our businesses with eToys Direct’s businesses will depend primarily on our ability to consolidate operations, systems and procedures of the two companies. There can be no assurance that we will succeed in these consolidation efforts.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2.
PROPERTIES
We do not own any real property. We lease approximately 9,700 square feet of office space in Jupiter, Florida. The lease commenced on April 1, 2006 for a 5-year and 9-month term, and the monthly lease cost is approximately $25,000.
We lease 9,800 square feet of office and warehouse space in Ft. Lauderdale, Florida that previously served as our corporate headquarters and distribution center under a lease that expires in May 2008. In June 2006, the Company entered into an agreement to sub-lease this space through April 30, 2008.
On December 15, 2005 we entered into a lease for approximately 23,000 square feet of warehouse space for a new distribution center in Las Vegas, Nevada that replaced the BabyUniverse distribution center in Ft. Lauderdale, Florida and the Dreamtime Baby warehouse in Culver City, California.
We leased approximately 4,000 square feet of office and warehouse space for our Dreamtime Baby business in Culver City, California under a lease that expired on March 31, 2006. Prior to that time, Dreamtime Baby’s inventory and certain of its employees were relocated to the Company’s new distribution center in Las Vegas, Nevada.
We leased approximately 7,625 square feet of office and warehouse space for the PoshTots headquarters in Virginia under a lease that expired on August 31, 2006. On February 28, 2006 we entered into a lease for approximately 12,000 square feet of office and warehouse space in Richmond, Virginia to replace the existing PoshTots headquarters space.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
We are not involved in any material litigation, administrative or governmental proceeding and none is believed by our management to be threatened.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of 2006.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our stock began trading on The Nasdaq Capital Market on March 27, 2006, after trading on the American Stock Exchange since August 3, 2005. At the same time, we changed our trading symbol from “BUN” to “POSH.” The following table shows the high and low trading prices for our common stock, as reported by the American Stock Exchange from August 3, 2005 through March 24, 2006, and as reported by The Nasdaq Capital Market from March 27, 2006 through December 29, 2006. The prices shown have been rounded to the nearest $1/100. As of March 27, 2007, the approximate number of shareholders of record of the Company’s common stock was 26, and the approximate number of beneficial owners of the Company’s common stock was 1,621.
We have not paid a dividend on any class of common stock and anticipate that we will retain future earnings, if any, to fund the development and growth of our business. Consequently, we do not anticipate paying cash dividends on our common stock in the foreseeable future.
Performance Graph
The information contained in this Performance Graph section of this Item 5 shall not be deemed to be “soliciting material” or “filed” or incorporated by reference in future filings with the Securities and Exchange Commission (“SEC”), or subject to the liabilities of Section 18 of the Securities Exchange Act of 1934, except to the extent that the Company specifically incorporates it by reference into a document filed under the Securities Act of 1933 or the Securities Exchange Act of 1934.
The graph below compares the performance of the Company’s Common Stock with the performance of the S&P 500 Index and a peer group index (the “Peer Group Index”) by measuring the respective changes in common stock prices from August 3, 2005, the first day of trading of the Company’s Common Stock after our initial public offering, through December 31, 2006, the last day of our 2006 fiscal year. The Company’s Common Stock ceased trading on the American Stock Exchange on March 24, 2006, and on March 27, 2006, began trading on The Nasdaq Capital Market.
Pursuant to the SEC’s rules, the Company created a peer group index with which to compare its own stock performance. The Company has selected a grouping of companies that it believes share similar characteristics to its own. The companies included in the Peer Group Index are as follows: Amazon.com Inc., Blue Nile Inc., iVillage Inc., Knot Inc., Odimo Inc. and RedEnvelope Inc.
The graph assumes that $100 was invested on August 3, 2005 in each of the Company’s Common Stock, the S&P 500 Index and the Peer Group Index, and that all dividends were reinvested into additional shares of the same class of equity securities at the frequency with which dividends are paid on such securities during the applicable fiscal year. The Peer Group Index weighs the returns of each constituent company according to its stock market capitalization at the beginning of each period for which a return is indicated.
INDEXED RETURNS
Months Ending
THE STOCK PRICE PERFORMANCE DEPICTED IN THE PERFORMANCE GRAPH IS NOT NECESSARILY INDICATIVE OF FUTURE PRICE PERFORMANCE. THE PERFORMANCE GRAPH WILL NOT BE DEEMED TO BE INCORPORATED BY REFERENCE IN ANY FILING BY THE COMPANY UNDER THE SECURITIES ACT OF 1933 OR THE SECURITIES EXCHANGE ACT OF 1934.
Equity Compensation Plan Information
Information with respect to compensation plans under which equity securities of the Company are authorized for issuance is presented in Item 12 of this Annual Report on Form 10-K under the caption “Equity Compensation Plan Information”, and is incorporated into this Item 5 by this reference.
Issuance of Unregistered Securities
On September 22, 2006, BabyUniverse, Inc. closed on $2 million in new equity financing. The equity financing was provided by affiliates of Wyndcrest Holdings, LLC, a company controlled by John C. Textor, our Chief Executive Officer. In connection with the financing, the Company received aggregate proceeds of approximately $2 million, based on the issuance of 263,852 shares of common stock priced at $7.58 per share, a 7.5% premium to the closing price on September 22, 2006. These funds are to be used for general corporate purposes. The shares of the common stock issued in this private placement were not registered under the Securities Act of 1933, pursuant to the exemption provided in Section 4(2)) thereof, and may not be subsequently offered or sold by the investors in the United States absent registration or an applicable exemption from the registration requirements. BabyUniverse filed a Registration Statement on Form S-3 (No. 333-139712) on December 28, 2006 covering registration of the common stock acquired by the investors pursuant to the private placement. This Registration Statement became effective on January 24, 2007.
On January 13, 2006, through a wholly owned subsidiary, we acquired substantially all of the assets of Posh Tots, LLC, in exchange for $6.0 million in cash, a Promissory Note for $6.0 million, 237,248 shares of our common stock and warrants to purchase 110,000 shares of our common stock at a price of $8.10 per share, which warrants became exercisable on January 13, 2007 and expire on January 13, 2008. The securities issued pursuant to this acquisition were not registered under the Securities Act of 1933, pursuant to the exemption provided in Section 4(2)) thereof, and may not be subsequently offered or sold in the United States absent registration or an applicable exemption from the registration requirements.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The following table sets forth selected consolidated financial data for each of the Company’s five most recent fiscal years. You should read the following selected consolidated financial data in conjunction with Part II, Item 7
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements include, among other things, statements regarding our future operations, financial condition, prospects and business strategies, and the consummation of our proposed merger with eToys Direct, Inc. These forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Annual Report on Form 10-K, and in particular, the risks discussed under the heading “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K and those discussed in other documents we file with the Securities and Exchange Commission. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.
The following discussion and analysis of financial condition and results of operations should be read together with “Selected Financial Data,” and our financial statements and accompanying notes appearing elsewhere in this Annual Report on Form 10-K.
Overview
BabyUniverse is a leading Internet content, commerce and new media company in the pregnancy, baby, toddler and maternity marketplace. Through its websites BabyUniverse.com and DreamtimeBaby.com, the Company is a leading online retailer of brand-name baby, toddler and maternity products in the United States. Through its websites PoshTots.com and PoshLiving.com, the Company has extended its offerings in the baby and toddler market as a leading online provider of luxury furnishings to the country’s most affluent female consumers. Through its websites PoshCravings.com, ePregnancy.com and BabyTV.com, BabyUniverse has also established a recognized platform for the delivery of content and new media resources to a national audience of expectant parents.
BabyUniverse is pursuing a dual strategy of organic growth and acquisition growth that is designed to establish BabyUniverse as the leader in the online baby marketplace. Beyond the baby segment, the Company intends to leverage its efficient and growing e-commerce platform to acquire other female-oriented e-commerce, marketing and new media companies. The overall objective of BabyUniverse is to establish a market-leading e-commerce and new media business focused on the high-growth female marketplace.
According to the United States Department of Commerce, the total online market for consumer products grew at a compound annual growth rate of 25.2% from $28.0 billion in 2000 to $86.3 billion in 2005. In the third quarter of 2006, this market continued expanding by growing 20.9% over the third quarter of 2005. Furthermore, the percentage of retail Internet sales occurring in the United States compared to total sales occurring at retail in the United States has increased from 0.9% in 2000 to 2.8% in the third quarter of 2006. eMarketer, Inc., a leading aggregator of online research reports, predicts that online retail sales will rise to $121 billion by 2007, or 2.9% of total retail sales. In addition, independent reports, including a May 2005 study by Forrester Research and a May 2005 report by e-Marketer, have indicated that women are becoming a more powerful driver of this growth in online purchasing activity. As the total online retail market continues to grow, we believe that the market for baby, toddler and maternity products sold over the Internet will also grow and that we are strategically positioned to participate substantially in such growth.
We offer over 35,000 products from over 600 manufacturers in easy-to-use online shopping environments that include baby, toddler and maternity accessories, apparel, bedding, furniture, toys and gifts. These products are available in a variety of styles, colors and sizes which account for over 750,000 stock keeping units (“SKUs”). We also provide expert buyer’s guides and in-depth product descriptions to assist our customers with finding quality products and to help parents make informed decisions about their babies’ and toddlers’ needs and safety. Overall, we provide a compelling combination of high quality products at competitive prices, a convenient shopping experience and excellent customer service that allows us to build an ongoing and potentially long-term relationship with our customers.
We review our operations based on both our financial results and various non-financial measures. Among the key financial factors upon which management focuses in reviewing performance are growth in sales, gross margin and operating income (or loss). As an online retailer, we do not incur many of the operating costs associated with physical retail stores. However, a significant amount of our operating expenses, as a percentage of net sales, is spent on online advertising and commissions instead of maintaining physical retail stores and sales staff. Our advertising and commission spending is an important factor in our sales growth, and we continuously monitor its effectiveness. Our financial results, including our sales, gross profit and operating income (or loss) can and do vary significantly from quarter to quarter as a result of a number of factors, many of which are beyond our control. These factors include general economic conditions, the costs to acquire our inventory and fulfill orders, the mix of our product sales and our competitors’ pricing and marketing strategies. Our total cost to fulfill orders is especially sensitive to potential fuel cost increases that may result from a continuing destabilization of world energy markets.
We generally own and hold only a portion of the inventory needed to support our level of sales. Although we are continuing to increase inventory of those items with lower risk due to higher demand and turnover, a significant portion of the inventory we offer is owned by our suppliers. This enables us to reduce some of the cost and risk associated with carrying a full inventory of the products we sell. Upon receipt of a customer order for a specific product that will be drop-shipped from a supplier, we simultaneously purchase that product from our supplier, who ships it directly to our customer. Since our inception, our business model has minimized inventory risk by maximizing the number of products we sell that are owned by others. However, as we execute our acquisition strategy, we may acquire businesses that use a different inventory model.
Among the key non-financial measures which management reviews are customer feedback, website traffic, sales conversion rates (i.e., the percentage of visitors to our websites who make a purchase) and number of orders. We believe that maintaining high overall customer satisfaction and an enjoyable shopping experience are critical to our ongoing efforts to promote our brands and to increase our sales and net income. We actively solicit customer feedback about our websites’ functionality as well as the entire shopping experience through third-party business rating and price comparison websites such as Shopping.com and BizRate.com. To maintain a high level of performance by our customer care representatives, we also undertake an ongoing customer feedback process. If we are unable to meet customer expectations with respect to price or do not successfully expand our product lines or otherwise fail to maintain high overall customer satisfaction, our financial condition and results of operations would be harmed.
We believe that we are one of the largest online retailers of baby, toddler and maternity products in terms of product offerings and revenues. As an industry leader, we have grown our business internally since inception by increasing our presence in what we have identified to be the largest and most efficient Internet portals and by keyword paid search advertising, resulting in substantially increased traffic to our websites. We have also increased our sales conversion rate by broadening our product offerings and by actively managing the placement of the best-selling products on our websites. As a result, our sales have increased substantially year over year since our inception.
The market for online retailers offering baby, toddler and maternity related products is highly fragmented, with a significant number of small competitors representing a significant percentage of total segment sales. We believe that our seasoned senior management team and our scalable business architecture make us well-suited to acquire both large and small industry competitors. As part of our acquisition strategy, we intend to preserve the goodwill and marketing relationships of acquired companies as necessary to maintain and grow market share. In addition, we may acquire companies that market products predominantly to women over the Internet, or companies that enhance our ability to market products to women.
Recent Developments
Strategic Alternatives
On August 14, 2006, BabyUniverse announced that its Board of Directors decided to begin a process to explore strategic alternatives to enhance shareholder value including, but not limited to, the acquisition of a substantial private company, the acquisition of a complementary public company or a potential sale of the Company. On October 5, 2006, the Company announced that it had retained Banc of America Securities LLC as its financial advisor. There can be no assurance that a transaction will result from this process and the Company does not intend to disclose developments regarding its exploration unless and until the Company’s Board of Directors has approved a specific transaction.
On March 13, 2007, the Company entered into a definitive Agreement and Plan of Merger (the “Merger Agreement”) with eToys Direct, Inc. (“eToys Direct”), an e-commerce and direct marketer of toys and other youth-related products. Under the terms of the Merger Agreement, which has been approved by the Company’s Board of Directors, the Company will exchange shares of its Common Stock, par value $0.001 per share (the “Common Stock”), for all the outstanding shares of eToys Direct. Immediately following the merger contemplated by the Merger Agreement (the “Merger”), BabyUniverse shareholders at the time immediately prior to the Merger will own approximately one-third, and eToys Direct shareholders at the time immediately prior to the Merger will own approximately two-thirds, of the outstanding Common Stock.
The Company and eToys Direct have made customary representations, warranties and covenants to one another in the Merger Agreement. Consummation of the Merger is subject to certain conditions, including, among others, the approval of the Merger Agreement by the holders of the Common Stock, the repayment by the Company of all of its indebtedness for borrowed money outstanding as of the closing of the Merger, and the absence of any law or order prohibiting the consummation of the Merger. The Merger Agreement contains certain termination rights for both the Company and eToys Direct, and further provides that, upon termination of the Merger Agreement under specified circumstances, the Company may be required to pay eToys Direct a termination fee of $1,567,178, and reimburse eToys Direct for the expenses incurred by it in connection with the transaction in a maximum amount of $1,500,000.
PoshTots Acquisition
On January 13, 2006, through our wholly owned subsidiary PoshTots, Inc., we acquired substantially all of the assets of Posh Tots, LLC (“PoshTots”), in exchange for $6.0 million in cash, a promissory note for $6.0 million, 237,248 shares of our common stock and warrants to purchase 110,000 shares of our common stock at a price of $8.10 per share. Through its primary website, PoshTots.com, the Richmond, Virginia-based PoshTots has long been recognized as a leading online retailer of high-end, artisan-crafted furniture to this country’s most affluent new mothers. Beyond the baby and children’s segments, PoshTots recently extended its brand with the Fall 2005 introduction of a new website, www.PoshLiving.com, offering designer quality home furnishings to its existing and growing base of affluent, predominantly female, customers. In March 2006, PoshTots introduced another new website, www.PoshCravings.com, designed as a content driven initiative targeted at the affluent female customer base already developed by PoshTots.
Purchase of Selected ePregnancy Assets
On June 15, 2006, the Company acquired certain assets related specifically to the business of ePregnancy.com and ePregnancy Magazine. The selected assets acquired include the URL www.ePregnancy.com, the ePregnancy trademark, a related online community website, message boards, and an expansive archive of content. The magazine’s prior owners discontinued publication of ePregnancy Magazine and the final published issue was distributed in late April as the May 2006 issue. BabyUniverse intends to focus its efforts on growing and supporting the online community at ePregnancy.com and does not intend to revive the magazine. The acquisition of these assets furthers the overall objective of BabyUniverse, which is to establish a market-leading e-commerce and new media business focused on the high-growth female marketplace.
Debt Financing Transactions
On July 11, 2006, the Company completed a $5.0 million debt financing transaction with Hercules Technology Growth Capital, Inc. (“Hercules”). Proceeds from the financing were used primarily to refinance the Company’s existing debt to the former owners of PoshTots, thereby enabling the Company to realize a negotiated $1.5 million discount of the $6.0 million note. The pre-payment and principal reduction in the note payable of $1.5 million was recognized in other income and expense as a gain on early extinguishment of debt in accordance with the accounting treatment prescribed by Accounting Principles Board Opinion (“APB”) 26, Early Extinguishment of Debt, and Statement of Financial Accounting Standards (“SFAS”) No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. The Company previously stated in its Quarterly Report on Form 10-Q for the quarter ended June 30, 2006 (See Note 9 to the unaudited financial statements contained therein - Subsequent Event) that, “The pre-payment and principal reduction in the note payable subsequent to June 30, 2006 will reduce the Company’s goodwill amount related to the PoshTots acquisition by $1.5 million.” This initial determination as to the proposed accounting treatment was based on limited consideration at that time of the relevant accounting pronouncements applicable to the underlying facts of this transaction. Based on subsequent review and consideration, the Company believes that SFAS 141, “Business Combinations”, is not relevant to the essential facts of this transaction.
The Senior Loan and Security Agreement between Hercules and the Company (the “Hercules Loan Agreement”) is for a term of 36 months, at an interest rate equal to the prime interest rate plus 2.35%. The Hercules Loan Agreement allows for interest-only payments for 12 months, with principal and interest payments due monthly thereafter. The interest-only period and the term of the underlying loan (the “Hercules Loan”) may be extended up to six months based on meeting certain financial tests. The Hercules Loan is secured by a perfected first priority security interest in all of the Company’s tangible and intangible assets and requires compliance with certain financial covenants, including a current ratio requirement, by which the Company must maintain a current ratio of at least .85 for the quarter ending September 30, 2006, at least .90 for the quarter ending December 31, 2006, and at least 1.0 for each subsequent calendar quarter thereafter. The Company was in compliance with all such covenants as of December 31, 2006.
In conjunction with the Hercules Loan Agreement, the Company issued a warrant to Hercules to purchase 91,912 shares of common stock of the Company at an exercise price of $8.16 per share. The warrant vested immediately upon execution of the Hercules Loan Agreement and is exercisable for seven years. The fair value of the warrant as of July 11, 2006 is $333,034, and the pro-rata value of the warrant will be classified as debt discount and amortized during the 36-month term of the Hercules Loan in accordance with APB No. 14.
On December 29, 2006, the Company entered into a Loan Agreement (the “Lydian Loan Agreement”) with Lydian Private Bank, pursuant to which Lydian Private Bank provided a term loan of $2,000,000 to the Company (the “Lydian Loan”), evidenced by a Promissory Note in that principal amount dated December 29, 2006 (the “Lydian Note”). The Lydian Loan bears interest at a floating rate of interest equal to the base rate on corporate loans posted by at least 75% of the nation’s largest banks, known as the “Wall Street Journal Prime,” which interest is payable monthly beginning on February 1, 2007. The maturity date of the Lydian Loan is July 1, 2008, at which time all outstanding principal and accrued but unpaid interest thereunder must be repaid to Lydian Private Bank.
As security for the Lydian Loan, Wyndcrest BabyUniverse Holdings II, LLC, a Florida limited liability company, and Wyndcrest BabyUniverse Holdings III, LLC, a Florida limited liability company, each of which is controlled by John C. Textor, the Company’s Chairman and Chief Executive Officer, pledged to Lydian Private Bank shares of the Company’s common stock held by them, which shares also serve as collateral under a loan previously extended to such pledgors by Lydian Private Bank. In addition, each such pledgor and Mr. Textor have executed a guaranty of the Lydian Loan in favor of Lydian Private Bank. The Lydian Loan Agreement and the Lydian Note contain customary events of default for facilities of this type; upon the occurrence of any such event of default, Lydian Private Bank shall be entitled to all rights and remedies available to it against the Company under law and the Lydian Loan Agreement and the Lydian Note, including, without limitation, the right to accelerate and demand immediate repayment of all sums due thereunder.
Private Placement of Equity Securities
On September 22, 2006, BabyUniverse closed on $2 million in new equity financing. The equity financing was provided by affiliates of Wyndcrest Holdings, LLC, a company controlled by the Company’s Chairman of the Board and Chief Executive Officer, John C. Textor. In connection with the financing, the Company received aggregate proceeds of approximately $2 million, based on the issuance of 263,852 shares of our common stock priced at $7.58 per share, a 7.5% premium to the closing price on September 22, 2006. These funds are to be used for general corporate purposes.
The shares of the common stock issued in this private placement were not registered under the Securities Act of 1933, pursuant to the exemption provided in Section 4(2)) thereof, and may not be subsequently offered or sold by investors in the United States absent registration or an applicable exemption from the registration requirements. BabyUniverse filed a Registration Statement on Form S-3 (No. 333-139712) on December 28, 2006 covering registration of the common stock acquired by the investors pursuant to the private placement. This Registration Statement became effective on January 24, 2007.
BabyTV.com
In December 2006 we launched our flagship new media venture, BabyTV.com, the Internet’s first integrated television-style broadcast channel and social networking community focused on the needs of new and expectant parents. BabyTV.com is delivered through an interactive format in which the consumer can tune in to broadcast-quality live and pre-recorded streaming television, interact through live events, respond to synchronized and targeted advertisements, engage in e-commerce transactions, browse links on the Web, and participate in BabyTV.com’s community features, without ever leaving the integrated broadcast platform.
The primary goal of BabyTV.com, and our other content sites, PoshCravings.com and ePregnancy.com, is to increase revenues from advertisers. We also intend BabyTV.com to build for our e-commerce sites the kind of loyalty with consumers that can be difficult to achieve in a pure e-commerce environment and to become a valuable driver of the BabyUniverse business strategy.
BabyTV.com has already partnered with the acclaimed women’s media company Oxygen Media Interactive, Inc., as well as video-on-demand pioneer Alpha Mom TV, Inc., to bring a wealth of informative and entertaining programming to our viewers. Oxygen’s “Oh!Baby” video on-demand (VOD) programming contributes segments of their popular shows, with content celebrating the highs and lows of parenthood. Alpha Mom contributes a deep catalog of informative programming featuring recognized experts on important topics from pregnancy through early child development. We plan to utilize these partnerships to cross-market to the 1.7 million monthly unique visitors of BabyUniverse-owned e-commerce properties such as BabyUniverse.com, PoshTots.com and DreamTimeBaby.com, and to content properties such as PoshCravings.com and ePregnancy.com.
Amazon Content Agreement
In December 2006, we reached an agreement with Amazon.com, Inc. to provide the rich content of our Internet sites, PoshCravings.com and ePregnancy.com, to Amazon.com consumers through the Amazon Baby marketplace.ePregnancy.com, a leading resource for both the expectant mother and new moms, offers valuable expert information as well as a vibrant online community. PoshCravings.com, launched in March 2006, has become a top style and trend destination for savvy moms and moms-to-be. Both sites boast a loyal following of visitors who seek the best advice, tips and trends as well as fabulous weekly giveaways.
Amazon is the first significant strategic relationship designed to support our long-communicated plan to transform BabyUniverse from a pure e-commerce company into a balanced content, commerce and new media concern. With an audience of more than 60 million active customer accounts, Amazon presents an opportunity for national brand prominence for our PoshCravings.com and ePregnancy.com content properties.
Operational Restructuring and Reorganization
During the first quarter of 2006, the Company initiated a multi-faceted reorganization and restructuring plan (the “Plan”), which was essentially completed during the second quarter of 2006. The objectives of the Plan were to (1) integrate the business operations of two recent acquisitions with the BabyUniverse e-commerce business in order to achieve greater efficiency, and (2) benefit from certain business strengths and best practices of the acquired organizations. The Plan was comprised of the following specific elements:
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Open the Company’s new distribution center in 23,000 square feet of leased space in Las Vegas in January 2006.
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Implement a new warehouse management system for the Las Vegas distribution center by late March 2006.
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Relocate DreamtimeBaby’s business operations and inventory from its Los Angeles-area headquarters to the Las Vegas distribution center by late March 2006.
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Relocate the BabyUniverse inventory and distribution activities from its Fort Lauderdale warehouse to the Las Vegas distribution center during February 2006.
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Restructure the BabyUniverse e-commerce business operations by consolidating substantially all activities within the PoshTots management organization in Richmond, Virginia during May 2006.
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Reorganize and consolidate the senior management organization in corporate offices in Jupiter, Florida during June 2006. The corporate office houses the Company’s executive management organization and certain corporate services including strategic planning, finance, technology, logistics and new media development.
The restructuring expenses related to the Plan were accounted for pursuant to SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses exit or disposal activities including one-time involuntary employee termination benefits, contract termination costs and costs to consolidate facilities or relocate employees. The total expense incurred for restructuring activities was approximately $538,000, of which $116,000 and $390,000 were recognized during the first and second quarters of 2006, respectively.
The major costs associated with implementing the Plan were as follows:
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One-time termination benefits were provided to certain current employees that were involuntarily terminated pursuant to the Plan, which was announced in February 2006. The affected employees were required to render service through various dates to June 30, 2006 in order to receive the termination benefits. The total expense incurred for one-time termination benefits was approximately $111,000. Approximately $43,000 and $68,000 of one-time termination benefits were recognized as restructuring expenses for the first and second quarters of 2006, respectively.
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We ceased using leased space for our offices and warehouse in Fort Lauderdale, Florida during the second quarter of 2006. We have recognized a liability of $72,752 during the quarter ended June 30, 2006, which represents the fair value of the lease costs that will continue to be incurred under the lease, net of sub-lease opportunities, for its remaining term through May 2008.
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Other costs incurred as a result of the restructuring include costs to consolidate or close our facilities in Fort Lauderdale and Los Angeles and to relocate certain activities to the Las Vegas distribution center, to PoshTots’ headquarters in Richmond, Virginia and to our corporate office in Jupiter, Florida. The total amount of other restructuring costs was approximately $323,000, most of which was incurred and recognized as restructuring expenses in the second quarter of 2006.
The Company experienced a significant amount of temporary but duplicative salary expense during the second quarter of 2006 due to the overlapping of positions during the extended training phase of its reorganization. A total of approximately 34 positions were relocated, replaced and retrained during this reorganization, and the cost of the overlapping salary expense included in restructuring expenses during the second quarter amounted to $151,831. Most of this duplication of salary expense ended during the second quarter, and the remainder ended during the first half of the third quarter.
Current Operating Environment
Throughout this period of restructuring, reorganization and business integration that began during the first quarter of 2006, the Company experienced substantial operational difficulties. Although the nature of these problems was anticipated at the outset of the reorganization and integration projects, the extent of the operating problems was not completely foreseen. These difficulties largely resulted from the complexity of simultaneously integrating within our newly-opened Las Vegas distribution center, both (1) the DreamtimeBaby business operations and inventory from their former location in Los Angeles, and (2) the BabyUniverse inventory and fulfillment operations from Fort Lauderdale. This consolidation project was further complicated by software problems associated with the newly-introduced warehouse management system in the Las Vegas distribution center, the additional complexity of relocating the BabyUniverse call center and much of its remaining business operations to PoshTots’ Richmond headquarters, and also the relocation and consolidation of senior management and the information technology, accounting and logistics functions from former offices in Fort Lauderdale, Florida to new executive offices in Jupiter, Florida.
During the second quarter of 2006, as a result of the restructuring, reorganization and business integration, we experienced an increased incidence of delayed shipments of customer orders, a higher level of order cancellations, and an increased level of product returns and discounts. These problems continued, to a lesser degree, during the third quarter, as we continued to focus significant attention and resources on resolving the cause of the various problems. As a result, our Amazon customer feedback has improved to a satisfaction score of more than 90%, from a low point in July 2006 of less than 60%.
However, the diversion of management’s attention from more normal activities during 2006 significantly impacted our sales performance during this period. Although site traffic across the BabyUniverse.com website increased 15% and 20% in September and October, respectively, compared to the same periods in the prior year, our conversion rates were lower in those months compared to the same periods in the prior year. This was directly attributable to the reduced availability of high velocity inventory items to fulfill sales orders due to organizational and procedural issues involving inventory ordering and replenishment. Newly-appointed operations management, replenishment process reengineering, and continued training of newly-hired employees during 2006 are expected to improve inventory availability and reduce backorders prospectively.
Our operating results during 2006 also were significantly impacted by increased salary and benefits and general and administrative expenses incurred (1) to expand the platform to support our acquisition growth strategy, and (2) to pursue the recent initiatives to expand our content and new media business, which is comprised of PoshCravings.com, ePregnancy.com and BabyTV.com.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances. However, estimates inherently relate to matters that are uncertain at the time the estimates are made, and are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments, or conditions.
Revenue Recognition
We have adopted the SEC Staff Accounting Bulletin (SAB) No. 101 - Revenue Recognition, which defines that revenue is both earned and realizable when the following four conditions are met: pervasive evidence of an arrangement exists; the selling price is fixed or determinable; delivery or performance has occurred; and collectibility is reasonably assured.
Per SEC Staff Accounting Bulletin (SAB) No. 104, which further clarifies SAB No. 101, if merchandise is shipped to our customers F.O.B. shipping point, title is considered to have transferred to the customer at the time the merchandise is delivered to the carrier. Our policy is to ship F.O.B. shipping point from our distribution center, third party warehouse and fulfillment center and drop ship locations, and therefore we recognize revenue at time of shipment.
We have also adopted EITF 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, as our formal guidelines for the recognition of revenue in our consolidated financial statements. All sales are completed through us and liability for product purchases is assumed by us. Therefore, we recognize the gross sales price as revenue.
Return allowances, which reduce gross sales, are estimated using historical experience.
The majority of our sales are processed through credit cards, and accounts receivable are composed primarily of amounts due from financial institutions for credit card sales. We do not maintain an allowance for doubtful accounts because payment is typically received one to two business days after the sale is completed.
Inventory
Inventory is accounted for using the first-in first-out (“FIFO”) method, and is valued at the lower of cost or market value. This valuation requires us to make judgments, based on currently available information, about the likely method of disposition, such as through sales to individual customers, returns to product vendors, or liquidations, and expected recoverable values of each method of disposition. Based on this evaluation, we adjust the carrying amount of our inventories to the lower of cost or market value.
As of December 31, 2006, the Company had a reserve for slow moving and obsolete inventory amounting to $49,000. No inventory reserves were recorded as of December 31, 2005. For most of our operating history, we have relied on drop ship arrangements and fulfillment partners to ship the majority of our sales orders, which minimizes our inventory levels and associated risks. Since 2004, we have increased the amount of our warehouse inventory to support a higher level of in-house fulfillment. The increased inventory levels are largely comprised of products that have a proven sales track record and a low risk of near-term obsolescence. However, with the recent emergence of this trend toward greater in-house fulfillment and increased inventory levels, the risk of inventory obsolescence has increased and there may be a need to recognize a reserve for obsolescence in the future.
Goodwill
SFAS No. 141, Business Combinations, requires that all business combinations be accounted for using the purchase method of accounting and that certain intangible assets acquired in a business combination be recognized as assets separate from goodwill. Goodwill is not subject to amortization and is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset may be impaired in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. The impairment test consists of a comparison of the fair value of the reporting unit with its carrying amount. If the carrying amount of the reporting unit exceeds its fair value, then an analysis will be performed to compare the implied fair value with the carrying amount of goodwill. An impairment loss would be recognized in an amount equal to the difference. Fair value is generally based upon future cash flows discounted at a rate that reflects the risk involved or market-based comparables. After an impairment loss is recognized, the adjusted carrying amount of goodwill becomes its new accounting basis.
Valuation of Deferred Tax Assets
We account for income taxes pursuant to SFAS No. 109, Accounting for Income Taxes, which requires that deferred tax assets be evaluated for future realization and reduced by a valuation allowance to the extent we believe a portion will not be realized. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our history of operating losses, expectations of future taxable income, and the carry-forward periods available to us for tax reporting purposes. Significant management judgment is required in evaluating these factors and in determining the amount of the valuation allowance to be recorded against our net deferred tax assets. For all periods presented the valuation allowance equals the total of our deferred tax assets due primarily to our history of operating losses and uncertainties related to expectations of future taxable income. The uncertainties relating to the valuation of our deferred tax assets are significant, and it is very difficult to predict when, if ever, our assessment may conclude that some or all of our deferred tax assets are realizable. In the event that actual results differ from these estimates and judgments, or we adjust these estimates in future periods, we may need to change the valuation allowance, which could materially impact our financial position and results of operations.
Stock-based Compensation
SFAS No. 123R, Share-Based Payment, is a revision of SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees. Effective January 1, 2006, the Company adopted the recognition and reporting requirements of SFAS No. 123R, and the corresponding recognition of compensation expense is included in our consolidated financial statements for 2006.
Prior to January 1, 2006, we applied APB No. 25 and related interpretations in accounting for stock-based transactions with employees and complied with the disclosure requirements of SFAS No. 123 and No. 148. SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of FASB Statement No. 123, amended SFAS No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amended the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.
Results of Operations
The following table presents our historical operating results for the periods indicated as a percentage of net sales:
The above table may not sum due to rounding.
The following describes certain line items set forth in our consolidated statements of operations:
Gross sales. Our gross sales relate to baby, toddler, maternity, bedding and furniture products sold through our websites, BabyUniverse.com, DreamtimeBaby.com, PoshTots.com and PoshLiving.com. The increase in gross sales from period to period is attributable to factors such as changes in our sales conversion rates, expanded product offerings, acquisitions of the DreamTimeBaby.com and PoshTots.com businesses, and the level of our advertising and commission spending. Our sales increases are a reflection primarily of increases in the volume of products shipped, rather than price increases or the introduction of new products. Shipping charges billed to customers are also included in gross sales.
Discounts and returns. Those products that are returned from customers, or that are discounted, are charged to discounts and returns, which are subtracted from gross sales to arrive at net sales.
Gross profit. Our gross profit consists of gross sales, less discounts and returns and cost of goods sold. Our cost of goods sold consists of the cost of products sold to customers, inbound and outbound shipping costs and insurance on shipments. Our gross margin consists of gross profit divided by net sales.
Operating expenses. Our major operating expenses consist primarily of advertising, including commissions related to our affiliate marketing program, salary and related benefit costs for our employees, and general and administrative expenses, including credit card fees and public company expenses.
Other income (expense). Other income (expense) generally includes interest income and interest expense.
Comparison of Year ended December 31, 2006 to Year ended December 31, 2005
The operational difficulties and their impact on the Company’s performance during 2006 relating to the restructuring, reorganization and business integration initiatives undertaken by the Company are described above in Management’s Discussion and Analysis of Financial Condition and Results of Operations - Recent Developments - Operational Restructuring and Reorganization, and - Current Operating Environment.
Gross sales. Gross sales increased 54.3% to $37.8 million for 2006 from $24.5 million last year. The most significant driver of our increase in gross sales was the consolidation of operating results of the businesses of DreamtimeBaby and PoshTots as of their September 13, 2005 and January 13, 2006 acquisition dates, respectively.
Discounts and returns. Discounts and returns amounted to $2.21 million, or 5.9% of gross sales for 2006, compared to $.81 million, or 3.3% of gross sales, for 2005.
Gross profit. Gross profit increased 61.9% to $10.2 million for 2006 from $6.3 million for 2005, and the increase primarily reflected the inclusion in 2006 of the operating results of the DreamtimeBaby and PoshTots acquisitions. The consolidated gross margin increased to 28.5% for 2006 compared to 26.5% for 2005. Most of the consolidated gross margin improvement reflected the benefit of the higher gross margin for the PoshTots brand, which exceeded 43% during 2006. Our gross profit in the fourth quarter of 2006 was negatively impacted by certain factors related to the company’s strategic alternatives process, including the suspension of certain cost saving and operating intiatives and high turnover of key operations and management personnel.
Operating expenses. Operating expenses increased to $14.6 million for 2006 from $6.9 million for 2005. As a percentage of net sales, operating expenses were 40.9 % for 2006 compared to 29.2 % for 2005. The increase in operating expenses as a percentage of net sales was primarily attributable to:
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restructuring expenses during the first and second quarter of 2006 of approximately $506,000 to open our new distribution center and to integrate the recent acquisitions of the businesses of DreamtimeBaby and PoshTots with the BabyUniverse e-commerce business,
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increased management salaries and technology-related depreciation expenses to expand the infrastructure to support our acquisition strategy, as well as the development of our content and new media business,
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increased general and administrative expenses incurred as a result of our becoming a public company in August 2005, including increased expenses for insurance, legal, accounting and investor relations,
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increased rent expense associated with the newly-developed Las Vegas distribution center, as well as office relocations and expansions for the PoshTots headquarters in Richmond, Virginia and the Company’s headquarters in Jupiter, Florida, and
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share-based compensation of $232,048, resulting from the adoption of SFAS No. 123(R), Share-Based Payment, effective January 1, 2006.
Advertising expenses improved to 13.1 % of net sales for 2006 from 14.7 % for 2005. The advertising expense improvement, as a percentage of net sales, was due to the substantially lower rate of advertising spending inherent in the DreamtimeBaby and PoshTots business models.
Other income (expense). Other income, net, was $1,047,688 for 2006 compared to $177,823 for 2005. Included in 2006 was a $1.5 million gain from extinguishment of debt (See Note 8 to our Consolidated Financial Statements - Notes and Capital Lease Payables), as well as $155,701 of interest income earned on cash and cash equivalents. These amounts were partially offset by $608,013 of interest expense for 2006.
Income taxes. There was no provision for income taxes for 2006 or 2005. We had net operating loss carry forwards of approximately $6,900,000 at December 31, 2006, which will expire in various years through 2026. We recorded a valuation allowance which fully offset the deferred tax benefit of the net operating loss carry forwards.
Net loss. The net loss for 2006 was $3,343,700, or ($.62) per diluted share, compared to a net loss of $492,297, or ($.13) per diluted share for 2005.
Comparison of Year ended December 31, 2005 to Year ended December 31, 2004
Gross sales. Gross sales increased 66% to $24.5 million for 2005 from $14.8 million for 2004. The increase in gross sales was due to several factors: increased web traffic resulting from higher levels of advertising to promote the BabyUniverse brand, an increase in our sales conversion rate and certain free shipping promotions. Our gross sales also increased due to the consolidation of DreamtimeBaby gross sales since September 13, 2005. We also believe that one of the key drivers of the growth of our sales is was the transition of purchases made by women through traditional outlets to purchases made over the Internet. This trend has been reported by market research firms including eMarketer, Inc. and Forrester Research.
Discounts and returns. Discounts and returns decreased to 3.4% of net sales for 2005 from 3.6% of net sales for 2004.
Gross profit. Gross profit increased 70.5% to $6.3 million for 2005 from $3.7 million for 2004. The increase in gross profit resulted from higher sales volumes. Gross margin improved to 26.5% for 2005 compared to 25.8% for 2004. In fact, our gross margin consistently improved every quarter in 2005, from a low of 23.0% in the first quarter to 30.1% in the fourth quarter.
Several important factors led to our improved gross margin performance throughout 2005. First during August, our largest vendor adopted a minimum Internet pricing policy, and this contributed to gross margin improvement for the last two quarters of the year. Secondly, our overall shipping costs benefited from economies of scale, despite higher gasoline surcharges. The third factor contributing to our gross margin improvement was the increasing percentage of our sales that were shipped from inventory, rather than from drop shippers. This percentage stood at about 50% as of December 2005 and grew consistently since the beginning of 2005, when it was approximately 30%. The final factor positively affecting our overall gross margin in 2005 was the consolidated benefit of higher gross margins in the range of 35% from the DreamtimeBaby acquisition.
Operating expenses. Operating expenses more than doubled to $6.9 million for 2005 from $3.5 million for 2004. As a percentage of net sales, operating expenses were 29.3% for 2005 compared to 24.3% for 2004. The increase in operating expenses as a percentage of net sales was almost entirely the result of additional infrastructure costs to support our acquisition strategy, as well as substantially higher general and administrative expenses incurred as a result of our becoming a public company in August 2005.
To a lesser extent, the increase in operating expenses was due to increased advertising and commission expenses, which, as a percentage of sales, increased to 14.7% for 2005 from 13.5% for 2004. These expenses were incurred in an effort to continue to rapidly build awareness of the BabyUniverse brand, drive net sales growth and gain market share as rapidly as possible in the highly fragmented and competitive market segment for the online sales of baby-related products.
Other income (expense). Other income, net, was $177,823 for 2005 compared to $1,204 for 2004, due to interest income earned on the net proceeds of the Company’s initial public offering of common stock in August 2005.
Income taxes. We had net operating loss carry forwards of 3,004,520 at December 31, 2005 which will expire in various years through 2025. Our net operating loss carry forwards at December 31, 2004 were $2,229,588. We recorded a valuation allowance which fully offset the deferred tax benefit of the net operating loss carry forwards for 2005 and 2004.
Net income (loss). The net loss for the full year 2005 was ($492,297), or ($0.13) per diluted share, compared to net income of $221,061, or $0.07 per diluted share for 2004. The most significant factor in this 2005 net loss was the aapproximately $591,000 investment in acquisition infrastructure and public company costs that we incurred during 2005.
Effect of Recent Accounting Pronouncements
In February 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments-an amendment of FASB Statements No. 133 and 140. This Statement amends FASB Statements No. 133, Accounting for Derivative Instruments and Hedging Activities, and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This Statement resolves issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” This Statement:
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Permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation.
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Clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133.
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Establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation.
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Clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives.
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Amends Statement 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.
This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Management does not expect adoption of SFAS No. 155 to have a material impact, if any, on the Company’s financial position or results of operations.
In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets an amendment of FASB Statement No. 140. This Statement amends FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, with respect to the accounting for separately recognized servicing assets and servicing liabilities. This Statement:
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Requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract.
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Requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable.
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Permits an entity to choose either the amortization method or the fair value measurement method for subsequent measurement for each class of separately recognized servicing assets and liabilities.
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At its initial adoption, permits a one-time reclassification of available-for-sale securities to trading securities by entities with recognized servicing rights, without calling into question the treatment of other available-for-sale securities under Statement No. 115.
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Requires separate presentation of servicing assets and liabilities subsequently measured at fair value in the statement of financial position and additional disclosures.
An entity should adopt this Statement as of the beginning of its first fiscal year that begins after September 15, 2006. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including interim financial statements, for any period of that fiscal year. The effective date of this Statement is the date an entity adopts the requirements of this Statement. The adoption of this Statement is not expected to have a material impact on the Company’s consolidated financial statements.
In June 2006, the Emerging Issues Task Force (“EITF”) issued EITF 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That is, Gross versus Net Presentation)” to clarify diversity in practice on the presentation of different types of taxes in the financial statements. The Task Force concluded that, for taxes within the scope of the issue, a company may adopt a policy of presenting taxes either gross within revenue or net. That is, it may include charges to customers for taxes within revenues and the charge for the taxes from the taxing authority within cost of sales, or, alternatively, it may net the charge to the customer and the charge from the taxing authority. If taxes subject to EITF 06-3 are significant, a company is required to disclose its accounting policy for presenting taxes and the amounts of such taxes that are recognized on a gross basis. The guidance in this consensus is effective for the first interim reporting period beginning after December 15, 2006 (the first quarter of our fiscal year 2007). We do not expect the adoption of EITF 06-3 will have a material impact on our consolidated results of operations, financial position or cash flow.
In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109. This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. Earlier application of the provisions of this Interpretation is encouraged if the enterprise has not yet issued financial statements, including interim financial statements, in the period this Interpretation is adopted. Management does not expect adoption of Interpretation No. 48 to have a material impact, if any, on the Company’s consolidated financial position or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines the fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Early adoption is encouraged, provided that a company has not yet issued financial statements for that fiscal year, including any financial statements for an interim period within that fiscal year. We are currently evaluating the impact SFAS 157 may have on our consolidated financial condition or results of operations.
In September 2006, the United States Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). This SAB provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB 108 establishes an approach that requires quantification of financial statement errors based on the effects of each of the company’s balance sheet and statement of operations and the related financial statement disclosures. The SAB permits existing public companies to record the cumulative effect of initially applying this approach in the first year ending after November 15, 2006 by recording the necessary correcting adjustments to the carrying values of assets and liabilities as of the beginning of that year with the offsetting adjustment recorded to the opening balance of retained earnings. Additionally, the use of the cumulative effect transition method requires detailed disclosure of the nature and amount of each individual error being corrected through the cumulative adjustment and how and when it arose. We are currently evaluating the impact SAB 108 may have on our consolidated financial condition or results of operations.
In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106, and 132(R). This Statement improves financial reporting by requiring an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income of a business entity or changes in unrestricted net assets of a not-for-profit organization. This Statement also improves financial reporting by requiring an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. An employer with publicly traded equity securities is required to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006. Earlier application of the recognition or measurement date provisions is encouraged; however, early application must be for all of an employer’s benefit plans. Retrospective application of this Statement is not permitted. Management does not expect adoption of SFAS No. 158 to have a material impact, if any, on the Company’s consolidated financial position or results of operations.
Liquidity and Capital Resources
Sources of funds and Liquidity. Since inception, we have funded our operations through the sale of equity securities and convertible indebtedness, and cash generated from operations. The significant components of our working capital are inventory and liquid assets such as cash and cash equivalents. As of December 31, 2005, our working capital was $8.7 million, which resulted primarily from the proceeds of our initial public offering of common stock in August 2005. As of December 31, 2006 we had negative working capital of approximately $44,000. The decline in working capital is primarily attributable to investing activities, described below under “Uses of funds”.
Net cash provided by financing activities for 2006 was approximately $4.0 million, and was primarily attributable to the debt and equity transactions described below. Net cash provided by financing activities for 2005 was $16.5 million, and was primarily attributable to BabyUniverse’s initial public offering of common stock in August, 2005.
During 2006, we completed the following debt and equity transactions to refinance existing debt and to raise funds for general corporate purposes:
•
On July 11, 2006, BabyUniverse completed a $5.0 million debt financing transaction with Hercules Technology Growth Capital, Inc. (NASDAQ: HTGC), a leading specialty finance company providing venture capital and private equity-backed technology and life science companies with debt and equity growth capital. Proceeds from the financing were used primarily to refinance BabyUniverse’s existing debt. (See Note 8 to our Consolidated Financial Statements - Notes and Capital Lease Payables)
•
On September 22, 2006, BabyUniverse closed on $2 million in new equity financing. The equity financing was provided by affiliates of Wyndcrest Holdings, LLC, a company controlled by our Chief Executive Officer John C. Textor. In connection with the financing, the Company received aggregate proceeds of approximately $2 million, based on the issuance of 263,852 shares of common stock priced at $7.58 per share, a 7.5% premium to the closing price on September 22, 2006. These funds are to be used for general corporate purposes. (See Note 17 to our Consolidated Financial Statements - Transactions With Related Parties)
•
On December 29, 2006, BabyUniverse entered into a Loan Agreement with Lydian Private Bank, pursuant to which Lydian Private Bank provided a term loan of $2,000,000 to the Company (the “Lydian Loan”), evidenced by a Promissory Note in that principal amount dated December 29, 2006. The Lydian Loan bears interest at a floating rate of interest equal to the base rate on corporate loans posted by at least 75% of the nation’s largest banks, known as the “Wall Street Journal Prime,” which interest is payable monthly beginning on February 1, 2007. The maturity date of the Lydian Loan is July 1, 2008, at which time all outstanding principal and accrued but unpaid interest thereunder must be repaid to Lydian Private Bank. (See Note 17 to our Consolidated Financial Statements - Transactions with Related Parties)
Uses of funds. Net cash used in operating activities for 2006 was $2,947,671, compared to net cash used by operating activities of $22,312 for 2005. The increase in cash used in operating activities was primarily due to the net loss in 2006 of $3,343,700 including a non-cash gain of $1,500,000 on extinguishment of debt, compared to a net loss in 2005 of $492,297.
Net cash used in investing activities for 2006 was approximately $7.5 million and was primarily related to the acquisition of PoshTots ($6.0 million), and to a lesser extent, capital expenditures ($1.6 million) associated with our business restructuring and integration, as well as enhancements to our technology system infrastructure.
On June 23, 2006, the Company’s credit card merchant agreement for its DreamtimeBaby business was unilaterally terminated by the processing company and funding bank, due to a recent increase in the volume of customer refunds and chargebacks. The unilateral termination of the merchant agreement was not confirmed to the Company until July 18, 2006, despite repeated attempts by the Company to clarify the then-existing situation. When confirmation of the termination was verbally received on July 18, 2006, the Company established a new credit card processing and funding account for its DreamtimeBaby business through another of its existing credit card processing agreements. In conjunction with termination of the agreement, and pursuant to rights based on its sole discretion, the funding bank unilaterally established a reserve account by withholding funding to the Company of credit card proceeds from June 23 until July 18, 2006. The resulting reserve account balance was $371,000. The Company negotiated the release of $270,000 of this reserve in December 2006 and another $90,000 was released to the Company in February 2007.
The proceeds from our initial public offering in August 2005 had been sufficient to fund our acquisitions and operational requirements through early 2006. The Company then secured the additional debt and equity financings described above in order to fund a repayment of its debt, as well as to provide additional working capital for general corporate purposes. We are currently evaluating a number of funding alternatives. It is possible that we could be required, or could elect, to seek additional funding through an equity or debt financing in the future, in order to fund strategic alternatives or our working capital or operational requirements, or to refinance our existing indebtedness. In addition, pursuant to the terms of the Merger Agreement, it is a condition to the closing of the Merger that the Company’s then existing indebtedness be repaid from the proceeds of an equity financing to be conducted by the Company after the date on which the Merger Agreement was executed. Any such future financing may not be available on terms acceptable to us, or at all.
As of December 31, 2006, we had no material commitments for capital expenditures.
Contractual Obligations
The following table summarizes our contractual obligations as of December 31, 2006 and the expected effect on liquidity and cash flows:
Payments due by period are as follows:
Off-Balance Sheet Arrangements
We do not have or engage in any off-balance sheet arrangements.
Impact of Inflation
The effect of inflation and changing prices on our operations was not significant during the periods presented.
Outstanding Stock Options
As of December 31, 2006, we had 236,248 options to purchase common shares outstanding, of which 113,082 are fully vested. The vested and unvested options have weighted average exercise prices of $4.22 and $8.68, respectively.
On October 1, 2004, we granted options to purchase 156,372 shares of common stock at an exercise price of $1.27 per share. We based the fair market valuation at that time on the Market Multiple and Discounted Cash Flow Approaches, coupled with the fact that we had not yet become profitable on a full year basis. While we believed that our business plan for organic growth was sound, we recognized that our opportunities to generate liquidity were relatively scarce and we had not yet been successful in attracting a credible investment bank in the pursuit of strategic alternatives. Our valuation was later confirmed by an independent appraisal that was obtained retrospectively in the second quarter of 2005.
On January 18, 2005, we granted additional options to purchase 52,124 shares of common stock at an exercise price of $6.25 per share. The $6.25 exercise price, which represented a significant increase from the October 1, 2004 fair market valuation, was based on the Market Multiple and Discounted Cash Flow Approaches, coupled with several significant developments. First, we had become profitable on a full-year basis for the first time in 2004. Second, we had adopted an expanded business plan, which would use strategic acquisitions to complement our organic growth initiatives. Third, our board of directors and management team had been expanded and strengthened to include a diverse group of business leaders who had significant experience in the financial, technology and retail sectors, with a particular emphasis on working for and with companies engaged in substantial acquisitions programs. These developments resulted in an increased interest from investment banks seeking to represent us in pursuing strategic alternatives and caused us to significantly adjust the fair market valuation of our company. Management chose not to seek an independent appraisal at this time, due to the referenced significant factors and preliminary discussions with investment banks regarding the value of our company.
On January 13, 2006, we granted options to purchase 50,000 shares of our common stock to officers of Posh Tots, LLC in connection with the Company’s purchase of the assets of Posh Tots, LLC. These options bore an exercise price of $8.10 per share, the closing price of our common stock on the American Stock Exchange on the date of the grant, vested over a two year period and expire after 25 months. Subsequent to January 13, 2006, options to purchase 30,000 of these shares were cancelled in connection with one such officer’s termination of employment with the Company.
On January 13, 2006, we granted options to purchase 75,000 shares of our common stock to employees of Posh Tots, LLC in connection with the Company’s purchase of the assets of Posh Tots, LLC. These options bore an exercise price of $8.10 per share, the closing price of our common stock on the American Stock Exchange on the date of the grant, vested over a three year period and expire after 37 months. Subsequent to January 13, 2006, options to purchase 15,000 of these shares were cancelled in connection with three such employees’ termination of employment with the Company.
On April 3, 2006, the Company granted options to purchase 50,000 shares of our common stock to a key employee involved in the development and implementation of the BabyTV new media concept. These options bear an exercise price of $9.86 per share, the closing price of the common stock on The Nasdaq Capital Market on the date of the grant, vest quarterly over a three year period and expire after 36 months.
On November 16, 2006, the Company granted options to purchase 2,000 shares of our common stock, to an employee. These options bear an exercise price of $6.84 per share, the closing price of the common stock on The Nasdaq Capital Market on the date of the grant, 25% of which vested immediately, with the remainder vesting over two years. These options expire in 25 months.
On December 11, 2006, the Company granted 25,000 restricted shares of our common stock to an employee. These restricted share vest over a four year period.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk. Our cash and cash equivalents balance as of December 31, 2006 was held in money market accounts or invested in investment grade commercial paper with maturities less than 90 days.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial statements and supplementary data for the Company appear on pages through following Item 15 of this Report and are incorporated herein by reference.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our periodic reports filed pursuant to the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified by the rules and forms of the Securities and Exchange Commission (“SEC”) and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow for 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 must apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by Rule 13a-15(b) of the Securities Exchange Act of 1934, we conducted an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.
In addition, there has been no change in our internal controls over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.
Our management, including our chief executive officer and our chief financial officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting are or will be capable of preventing or detecting all errors and all fraud. Any control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Our Board of Directors currently consists of seven directors, divided into three classes with members of each class of directors serving for staggered three-year terms. Our current Board members and classifications are as follows:
Class I
Class II
Class III
Curtis S. Gimson
Carl Stork
Stuart Goffman
Bethel G. Gottlieb
Jonathan Teaford
John Nichols
John C. Textor
Terms for the Class I, II and III Directors expire at the annual meetings for 2009, 2007 and 2008, respectively.
John C. Textor, 41, has been Chairman of our Board of Directors since November 2002 and a member of our Board of Directors since December 1999. Mr. Textor has served as our Chief Executive Officer since April 2005. He is also the Founder and President of Wyndcrest Holdings, LLC, a Florida-based private holding company focused on technology-related opportunities in entertainment, telecommunications and the Internet, and its predecessor since 1997.
Earlier, Mr. Textor was employed in various merchant banking and investment banking capacities by Shearson Lehman Hutton and Paine Webber. Mr. Textor was also a founding director of Lydian Trust Company, a diversified financial services company. He is currently a director of Multicast Media Networks, Inc., a global provider of Internet-based broadcast media. He was previously Chairman of the Board of Sims Snowboards, a prominent global snowboard brand. Mr. Textor earned a B.A. degree in Economics at Wesleyan University.
Carl Stork, 47, became a member of our Board of Directors in October 2004. Mr. Stork is President and Founder of Ciconia & Co, LLC, a private investment firm based in Seattle, Washington. Mr. Stork is Chief Executive Officer of Digital Domain, Inc., an award winning visual effects and digital media company in Venice, California. He is also a non-managing member of Wyndcrest Holdings, LLC. Prior to founding Ciconia, Mr. Stork had a long and varied career at Microsoft Corporation from 1981 to 2002, serving in a variety of executive management positions, including technical assistant to Bill Gates, General Manager of Windows 95/98 Development and General Manager of Hardware Strategy and Business Development. Mr. Stork served on the board of directors of Lydian Trust Company until March 2005, and currently serves on the board of directors of Neomagic Corporation, a publicly traded company which develops application processors for hand held devices. Mr. Stork is a partner in the Baseball Club of Seattle, owner of the Seattle Mariners major league baseball team. Mr. Stork earned an MBA degree at the University of Washington and a B.A. degree in Physics at Harvard University.
John Nichols, 55, became a member of our Board of Directors in January 2005. Mr. Nichols is Chief Financial Officer, Secretary and Treasurer of Varsity Brands, Inc., a manufacturer and marketer of branded products and services for the educational extracurricular market, including team sports and cheerleading. He also served as Senior Vice President, Finance of Varsity Spirit Corporation, a publicly-traded predecessor of Varsity Brands, Inc., since July 1992 and Chief Financial Officer since April 1994. Mr. Nichols earned his B.B.A. degree in Accounting at the University of Memphis and a M.S.M. degree in Accounting at Florida International University.
Curtis S. Gimson, 51, became a member of our Board of Directors in April 2005. Mr. Gimson has been Senior Vice President of Arby’s Restaurant Group, Inc. since 1997, and served as General Counsel of Arby’s Restaurant Group from 1997 until 2005. In 1984, he joined Triangle Industries, Inc., a public company controlled by Nelson Peltz and Peter May, and has worked in various capacities for companies controlled by Messrs. Peltz and May for the past 22 years, including as Associate General Counsel of Triangle 1984-89, Senior Vice President & General Counsel, Trian Group, L.P., 1989-93, Senior Vice President & Associate General Counsel of Triarc Companies, Inc., 1993-94, Senior Vice President & General Counsel, Royal Crown Cola Co., 1994-97, and Senior Vice President & General Counsel of Arby’s since 1997. Mr. Gimson earned his B.A. degree at Princeton University and his J.D. degree at Cornell Law School.
Bethel G. Gottlieb, 38, became a member of our Board of Directors in June 2005. From 1995 to 2000, Ms. Gottlieb served in progressively senior merchandising management positions for May Department Stores and Federated Department Stores. While at Federated Department Stores, Ms. Gottlieb was responsible for overseeing the merchandising strategy and product development for all store divisions. From 2000 to the present, Ms. Gottlieb has remained at home caring for her young children. Ms. Gottlieb earned a B.A. degree in Psychology from Wesleyan University and an M.B.A. degree from Harvard University Graduate School of Business.
Stuart Goffman, 40, was our interim Chief Financial Officer from October 2006 to December 2006, our Chief Operating Officer from January 2005 through October 2006 , our President from October 2002 through January 2005, and a member of our Board of Directors since October 1998. In June 2000, Mr. Goffman left BabyUniverse and co-founded and became the Chief Operating Officer and director of ChildU, Inc., a distance learning company specializing in online education for grades K-8. ChildU, Inc., was acquired by WRC Media, Inc. in May 2001. Mr. Goffman rejoined BabyUniverse in October 2002 and was our Chief Executive Officer from October 2002 to April 2005. Mr. Goffman was previously employed by Grant Thornton in New York. Mr. Goffman is a Certified Public Accountant (“CPA”) certified in the State of Georgia. He earned a B.S. degree in Accounting at the University of Florida.
Jonathan Teaford, 33, has been our Executive Vice President since January 2005 and has been a member of our Board of Directors since December 2000. Mr. Teaford has been a partner with Wyndcrest Holdings, LLC, since March 2002. Prior to joining Wyndcrest’s predecessor in January 1998, Mr. Teaford was employed by GE Capital Services, a subsidiary of General Electric. Mr. Teaford earned a B.A. in Economics at Hamilton College.
Board of Advisors
In addition to our Board of Directors, we have a Board of Advisors. The Board of Advisor’s purpose is solely to provide non-binding advice and counsel to our Board of Directors. The current members of our Board of Advisors are as follows:
Michael Bay
Kenneth Goore
Dan Marino
Michael Bay became a member of our Board of Advisors in October 2004 and has served as an informal advisor to the company since October 2002. Mr. Bay is a principal of Bay Films, Inc. Mr. Bay has produced and directed the major motion pictures Armageddon, Pearl Harbor, and The Island. He also directed Bad Boys, The Rock, and Bad Boys II. Through his production company, Platinum Dunes Productions, he also produced The Texas Chainsaw Massacre (2003) and The Amityville Horror (2005). He has filmed television commercials for many major advertisers including Nike, Coca-Cola, Levi’s, and for the Got Milk campaign. He has also filmed award winning music videos for artists including Aerosmith, Tina Turner, Meatloaf and Divinyls. Mr. Bay earned a B.A. degree in English and Film at Wesleyan University.
Kenneth Goore became a member of our Board of Advisors in April 2005. In 1992, Mr. Goore co-founded Goore’s For Babies to Teens, which today is one of the largest specialty baby and children’s retail stores in the western United States. Mr. Goore earned a B.S. degree in Marketing and Finance at the University of Akron.
Dan Marino became a member of our Board of Advisors in October 2004. In April 2000, Mr. Marino announced his retirement from professional football after 17 consecutive seasons with the Miami Dolphins of the National Football League. He has since established himself as a leading television sports commentator through his work with the CBS NFL Today show and HBO’s Inside the NFL. His ongoing work for the community is centered on the Dan Marino Foundation for children’s charities of South Florida. Mr. Marino earned a B.A. degree in Communications at the University of Pittsburgh.
Compensation of Directors
We pay each non-employee director an annual retainer of $5,000. We pay each non-employee director $500 for each committee meeting attended. We also pay certain reasonable expenses incurred by our directors and members of our Board of Advisors.
Non-employee directors and Board of Advisors members may be granted restricted stock or options pursuant to the BabyUniverse 2005 Stock Incentive Plan. Our non-employee directors will be eligible to receive restricted stock or options to the extent granted by our Compensation Committee. We may, in our discretion, grant additional restricted stock or options and other equity awards to our non-employee directors and members of our Board of Advisors from time to time.
Independence of the Board
The Board of Directors has determined that the following four individuals of its seven members are independent as defined under the federal securities laws, including Rule 10A-3(b)(i) under the Securities Exchange Act of 1934, and the Nasdaq Marketplace Rules: Mr. Gimson, Ms. Gottlieb, Mr. Nichols and Mr. Stork.
Committees and Meetings of the Board of Directors
The Board of Directors held nine meetings, including four regularly scheduled meetings and five special meetings, during the year ended December 31, 2006. It is the policy of the Board of Directors to encourage attendance at Board and committee meetings. Each director attended at least 75% or more of the aggregate number of meetings held by the Board of Directors and the committees on which he or she served. Our Board of Directors has three standing committees: the Audit Committee, the Compensation Committee and the Nominating Committee.
Audit Committee. The Audit Committee presently consists of Messrs. Gimson, Stork, and Nichols, who serves as chairman. The Audit Committee is responsible for reviewing and monitoring our financial statements and internal accounting procedures, recommending the selection of independent auditors by our Board of Directors, evaluating the scope of the annual audit, reviewing audit results, consulting with management and our independent auditor prior to presentation of financial statements to shareholders and, as appropriate, initiating inquiries into aspects of our internal accounting controls and financial affairs. Our Board of Directors has determined that Mr. Nichols qualifies as an “audit committee financial expert” under the federal securities laws. The Audit Committee’s responsibilities are set forth in an Audit Committee Charter, a copy of which can be found on the Company’s website, www.babyuniverse.com. The Audit Committee held six meetings during the year ended December 31, 2006.
Compensation Committee. The Compensation Committee presently consists of Ms. Gottlieb, Mr. Nichols and Mr. Gimson, who serves as chairman. The Compensation Committee is responsible for reviewing and recommending to the Board of Directors the compensation and benefits of all of our executive officers, administering our stock incentive plan and establishing and reviewing general policies relating to compensation and benefits of our employees. The Compensation Committee’s responsibilities are set forth in a Compensation Committee Charter, a copy of which can be found on the Company’s website, www.babyuniverse.com. The Compensation Committee held three meetings during the year ended December 31, 2006.
Nominating Committee. The Nominating Committee presently consists of Ms. Gottlieb, Mr. Stork and Mr. Gimson, who serves as chairman. The Nominating Committee is responsible for identifying prospective Board of Directors candidates, recommending nominees for election to our Board of Directors, developing and recommending Board of Directors member selection criteria, considering committee member qualifications and providing oversight in the evaluation of the Board of Directors and each committee. The Nominating Committee will consider director nominee recommendations by shareholders, provided that the names of such nominees and their relevant biographical information are properly submitted in the manner described in the Company’s proxy statement relating to its 2006 Annual Meeting of Shareholders under the caption “General Information - Shareholder Proposals and Director Nominations for 2007 Annual Meeting.” The Nominating Committee’s responsibilities are set forth in a Nominating Committee Charter, a copy of which can be found on the Company’s website, www.babyuniverse.com. The Nominating Committee held one meeting during the year ended December 31, 2006.
Code of Business Conduct and Ethics
Our Board of Directors has adopted a Code of Business Conduct and Ethics applicable to our directors, officers and employees, in accordance with applicable federal securities laws and Nasdaq Marketplace Rules. Our Code of Business Conduct and Ethics is available to view at our website, www.babyuniverse.com.
EXECUTIVE OFFICERS AND KEY EMPLOYEES
As of March 29, 2007, each of the persons named below served as one of our executive officers or key employees.
Name
Age
Position
John C. Textor
Chief Executive Officer
Georgianne K. Brown
President Mainstream eCommerce
Jonathan Teaford
Executive Vice President
Michael R. Hull
Chief Financial Officer
John Studdard
Executive Vice President - New Media
Each executive officer is appointed by and serves at the discretion of our Board of Directors, subject, in certain cases, to the terms of an employment agreement with the Company.
Below is a summary of the business experience of each of our executive officers who do not serve on our Board of Directors.
Georgianne K. Brown, 46, has been our President of Mainstream eCommerce since October 2006 and was our Executive Vice President of Marketing from July 2005 to October 2006. Ms. Brown was formerly the Vice President for Marketing Services for eDiets.com, Inc., a public company that provides online diet and fitness subscription products and services, from November 2003 to April 2005. Ms. Brown held a variety of positions in Certified Vacations Group, Inc. from November 1997 to July 2003, holding the title of Vice President for Consumer Marketing from 1998 to 2003. In 1998, she also become the President of New River Technologies, a subsidiary of Certified Vacations Group, Inc. Ms. Brown held several marketing and sales related positions with Alamo Rent A Car, Inc. from 1979 to 1997, and was the Executive Director of Consumer Marketing for Alamo Rent A Car, Inc. from 1996 to 1997.
Michael R. Hull, 53, has been our Chief Financial Officer since December 2006. From December 2004 through December 2006, Mr. Hull assisted a large multinational company in complying with Section 404 of the Sarbanes-Oxley Act of 2002. Previously Mr. Hull served as Chief Financial Officer, Secretary and Treasurer of BCT International, Inc., a public company that franchised wholesale printing businesses, from May 1996 to August 2004.
John Studdard, 39, has been our Executive Vice President of New Media since April 2006. Mr. Studdard also served in the capacity of interim Chief Technology Officer and served as an IT and management consultant to the Company from July 2005 to March 2006. Prior to joining the Company, Mr. Studdard was the Chief Information Officer and Senior Vice President of Palm Beach, Florida-based Lydian Trust Company, by whom he was employed from 1990 until 2005.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934 requires our directors and executive officers and persons who own more than 10% of our outstanding Common Stock to file with the Securities and Exchange Commission (“SEC”) reports of changes in their ownership of Common Stock. Officers, directors and greater than 10% shareholders are also required to furnish us with copies of all forms they file under this regulation. To our knowledge, based solely on a review of the copies of such reports furnished to us and representations that no other reports were required, during the year ended December 31, 2006, all Section 16(a) filing requirements applicable to our officers, directors and greater than 10% shareholders were complied with, except that John C. Textor reported the acquisition on December 15, 2006 of 3,700 shares of the Company’s common stock on a Form 4 filed with the SEC on December 21, 2006.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
Compensation Discussion and Analysis
The following discussions and tables in this Item 11 set forth information with regard to compensation for services rendered in all capacities to the Company and its subsidiaries during the year ended December 31, 2006, by the Chief Executive Officer (CEO), the Chief Financial Officer (CFO), the three most highly compensated executive officers of the Company, other than the CEO and CFO, who were serving as executive officers at December 31, 2006, and two additional individuals who were no longer serving as executive officers at December 31, 2006 (the “Named Executive Officers”). The information discussed below reflects the compensation earned by such individuals for services with the Company and its subsidiaries during the covered periods.
Company Compensation Objectives
The Company’s objective is to maintain a program of executive compensation that is competitive and motivating to the degree that it will attract, retain and inspire performance of executive officers who possess qualities, talents and abilities that will enhance the growth and profit potential of the Company. The Company believes that its compensation program must include both short term and long term compensation elements. Our Board has organized a Compensation Committee to establish the Company’s program of executive compensation.
Elements of Executive Compensation
The Compensation Committee of the Company’s Board of Directors is responsible for overseeing our compensation programs. As part of that responsibility, the Compensation Committee determines all compensation for the Chief Executive Officer and the Company’s other executive officers as defined by SEC rules.
The Company’s executive compensation program consists of a competitive base salary, equity participation either in the form of options to purchase shares of the Company’s common stock or the granting of restricted shares of the Company’s common stock, which, in each case, vest over a two to four year period. In addition, the Company has paid discretionary bonuses which are based on the Compensation Committee’s assessment of the executive’s contribution to the Company.
The Company attempts to set base salaries that are competitive with similar sized organizations, are commensurate with each executive’s organizational responsibilities and his or her level of professional development, taking into account the expected role the executive is likely to play in the helping the Company achieve its goals and objectives. In addition, after the Compensation Committee evaluated the roles and responsibilities of the executive officers, each executive officer was allowed to invest in equity of the Company or was awarded equity in the form of restricted stock or stock options in connection with his or her employment. Equity-based compensation is designed to provide long-term incentives for the aligning of the Company’s goals and objectives with the executive’s performance and to reward performance that is accretive to shareholder value. The Compensation Committee believes these arrangements are reasonable and competitive compared to other companies the Company competes with for the attraction and retention of talent.
The executive officers do not receive any other compensation or benefits other than standard benefits available to all employees, which primarily consist of health plans, the opportunity to participate in the Company’s 401(k) plan, basic life insurance and accidental death insurance coverage.
Equity Compensation Grants
The Compensation Committee is responsible for establishing and administering the Company’s equity compensation programs and for awarding equity compensation to the executive officers. To date, the sole forms of equity compensation awarded to or purchased by officers and employees have been restricted stock and stock options. The Compensation Committee believes that restricted stock and stock options are an important part of overall compensation because they align the interests of officers and other employees with those of our shareholders and create long-term incentives to maximize shareholder value.
Chief Executive Officer’s Compensation
The Compensation Committee considered the following factors in determining the compensation for fiscal 2006 for John C. Textor, Chairman of the Board and Chief Executive Officer: the terms of his employment agreement with the Company and the Company’s financial performance for 2005. The base salary for Mr. Textor pursuant to the terms of his employment contract as of the beginning of the year was $90,000, subject to discretionary increases from time to time by the Board of Directors or the Compensation Committee. In November of 2006, the Board of Directors approved increasing Mr. Textor’s annual base salary to $225,000. In establishing Mr. Textor’s base salary, the Compensation Committee took into consideration the current compensation levels of CEOs of comparable ecommerce companies.
Base Salaries of Other Executive Officers
Executive officers’ salaries are determined pursuant to the terms of their respective employment agreements. In cases where base salary increases are at the discretion of the Compensation Committee pursuant to the terms of an executive officer’s employment agreement, the Compensation Committee annually reviews base salaries and any increases are based on the Company’s overall performance and the executive’s individual performance during the preceding year. A cash bonus of $25,000 was paid to Georgianne K. Brown in 2006. No other cash bonuses were paid to executive officers in 2006.
Review of all Components of Executive Compensation
The Compensation Committee has reviewed all components of the executive officers’ compensation, including salary, bonus, equity compensation, and accumulated realized and unrealized stock option gains.
Employment Agreements
Each of the Company’s Named Executive Officers has entered into an employment agreement with the Company, which establishes such executive officer’s base salary and bonus, if applicable. Among other things, the employment agreements generally provide for severance, upon termination other than for cause, designate a period of employment, allow the termination of the agreement by either party with notice and grant the right to participate in the Company’s discretionary bonus program.
Summary Compensation Table
The following table presents certain summary information, as applicable, for the fiscal years ended December 31, 2006, 2005 and 2004 concerning compensation earned for services rendered in all capacities to the Company and its subsidiaries by the Named Executive Officers during the covered periods. In accordance with the newly promulgated rules of the Securities and Exchange Commission related to Executive Compensation disclosure, this table includes newly required information only for the Company’s fiscal year ended December 31, 2006.
Summary Compensation Table
Grants of Plan -Based Awards
The following table sets forth information concerning the grants of plan-based awards to the Named Executive Officers under our BabyUniverse 2005 Stock Incentive Plan during our last completed fiscal year:
Grants of Plan-Based Awards
(1)
In September 2006, Karen Adams left the employment of the Company. Ms. Adams’ options were forfeited effective as of the date she left the Company.
Outstanding Equity Awards at Fiscal Year End
The following table provides certain information concerning unexercised options, stock that has not vested, and equity incentive plan awards for each Named Executive Officer outstanding as of the end of the 2006 fiscal year:
Outstanding Equity Awards at December 31, 2006
The following table provides information regarding the options exercised by, and the vesting of stock for, the Named Executive Officers during fiscal 2006 and the value realized on such exercise or vesting:
(1)
Based on the fair market value of our Common Stock on the date of vesting.
Pension Benefits and Nonqualified Deferred Compensation
The Company has not provided, and does not currently provide, any form of post-retirement benefits to its employees or any of the Named Executive Officers. In addition, the Company has never had, and currently does not have, any nonqualified deferred compensation plans in place.
Employment Agreements
We previously entered into employment agreements with John C. Textor, our Chairman of the Board and Chief Executive Officer, Jonathan Teaford, our Executive Vice President, Robert Brown, our former Chief Financial Officer, and Georgianne K. Brown, our former Executive Vice President of Marketing. During 2006 we entered into employment agreements with John Studdard, our Executive Vice President for New Media, and Michael R. Hull, our Chief Financial Officer, ratified amendments to the employment agreements for John C. Textor and Jonathan Teaford and entered into a new employment agreement with Georgianne K. Brown for her new position of President - Mainstream eCommerce. The employment agreements with Messrs. Textor, Teaford and Brown are each for initial terms of three years, with successive one year extensions unless we or the employee timely provides the required notice of the intent not to renew the agreement. Mr. Brown resigned his position in October 2006. The employment agreements with Ms. Brown and Mr. Hull are for initial terms of one year, with successive one year extensions unless we or they timely provide the required notice of the intent not to renew the agreement. The new agreements and the ratified amendments provide for annual base salaries of $225,000 for Mr. Textor, $180,000 for Mr. Studdard, $120,000 for Mr. Teaford, $140,000 for Ms. Brown and $135,000 for Mr. Hull, plus discretionary annual cash bonuses determined by the Compensation Committee of our Board of Directors. In addition, Mr. Studdard received options to purchase 50,000 shares of our common stock which vest quarterly over four years. Mr. Hull received 25,000 shares of restricted common stock vesting over four years.
Each of the agreements also prohibits the employee from competing with us with respect to any business that is engaged in selling brand name baby, toddler, kids or maternity products, for the period of employment and for three years thereafter. The agreements also prohibit the employees from soliciting our customers to divert their business away from us or soliciting our employees or independent contractors to work for a business that competes with us, or for our suppliers, for the period of his or her employment and for three years thereafter.
The agreements provide that if (1) a change of control (as described below) occurs, (2) such change of control results in a decrease in the employee’s compensation, responsibilities or position, such that the employee cannot in good faith continue to fulfill his or her job responsibilities (as determined by the employee in his/her sole discretion during the six month period following the change of control), and (3) the change of control did not occur due to the employee’s intentional bulk sale of his or her shares of our common stock, then the employee has the right to terminate his or her employment agreement and receive in one lump sum a payment equivalent to his or her accrued salary and benefits plus a severance benefit equal to one-twelfth of his or her then base salary with an additional one-twelfth of his or her then base salary for each full calendar year that the employment agreement and any extension thereof shall have been in effect and any applicable expense reimbursements. A “change of control” generally means a merger or other change in corporate structure after which the majority of our capital stock is no longer held by the shareholders who held such shares prior to the change of control, a sale of substantially all of our assets to a non-subsidiary purchaser or a reorganization merger or consolidation in which we or a subsidiary is not the surviving corporation.
The following table describes potential payments to the Named Executive Officers at, following or in connection with any termination of their employment with the Company, including, without limitation, as a result of resignation, severance, retirement or a change in control of the Company or material changes in the Named Executive Officer’s responsibilities or status at the Company:
Compensation of Directors
The following table provides a summary of compensation paid to the Company’s non-employee directors during the year ended December 31, 2006:
Director Compensation
Compensation Committee Interlocks and Insider Participation
During the fiscal year ended December 31, 2006, the Compensation Committee of the Board of Directors of the Company was comprised of Bethel G. Gottlieb, John Nichols, and Curtis Gimson, who served as Chairman. No other disclosures concerning any such member of the Compensation Committee are required to be included under this caption in this Annual Report on Form 10-K.
COMPENSATION COMMITTEE REPORT
The information contained in this report shall not be deemed to be “soliciting material” or “filed” or incorporated by reference in future filings with the SEC, or subject to the liabilities of Section 18 of the Securities Exchange Act of 1934, except to the extent that we specifically incorporate it by reference into a document filed under the Securities Act of 1933 or the Securities Exchange Act of 1934.
The members of the Compensation Committee of the Company’s Board of Directors have reviewed and discussed the Compensation Discussion and Analysis appearing in this Annual Report on Form 10-K with management, and based upon such review and discussion, the Compensation Committee recommended to the Company’s Board of Directors that such Compensation Discussion and Analysis be included in this Annual Report on Form 10-K.
The Compensation Committee
Curtis Gimson
Bethel G. Gottlieb
John Nichols
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information regarding the beneficial ownership of our common stock as of March 20, 2007 by:
•
each person known by us to be the beneficial owner of more than five percent (5%) of our outstanding shares of our common stock;
•
each of our executive officers and directors; and
•
all of our executive officers and directors as a group.
Beneficial ownership is determined in accordance with the rules of the SEC and includes voting or investment power with respect to the shares. In computing the number of shares beneficially owned by a person and the percentage ownership of that person, shares of Common Stock subject to options or warrants held by that person that are currently exercisable or will become exercisable within 60 days after March 20, 2007, are deemed outstanding, while the shares are not deemed outstanding for purposes of computing percentage ownership of any other person. Except as otherwise indicated, and subject to applicable community property laws, the persons named in the table have sole voting and investment power with respect to all shares of common stock held by them.
Applicable percentage ownership in the following table is based on 5,686,470 shares of Common Stock outstanding as of March 20, 2007. Unless otherwise indicated, the address where each of the shareholders in the table below may be contacted is c/o BabyUniverse, Inc., 150 South US Highway One, Suite 500, Jupiter, Florida 33477.
Equity Compensation Plan Information
The following table sets forth information, as of December 31, 2006, with respect to our compensation plans under which Common Stock is or was authorized for issuance and is outstanding:
Change in Control
In the event that the Company’s proposed merger with eToys Direct, Inc. is consummated, the Company will undergo a change of control, with the shareholders of eToys Direct, Inc. immediately prior to the consummation of the merger owning, in the aggregate, approximately two-thirds of the outstanding Common Stock immediately after such consummation.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Certain Relationships and Related Transactions
On September 22, 2006, the Company closed on $2 million in new equity financing. The equity financing was provided by affiliates of Wyndcrest Holdings, LLC, a company controlled by our Chairman and Chief Executive Officer John C. Textor. In connection with the financing, the Company received aggregate proceeds of approximately $2 million, based on the issuance of 263,852 shares of our common stock priced at $7.58 per share, a 7.5% premium to the closing price on September 22, 2006.
On December 29, 2006, the Company entered into a Loan Agreement (the “Lydian Loan Agreement”) with Lydian Private Bank, pursuant to which Lydian Private Bank provided a term loan of $2,000,000 to the Company (the “Lydian Loan”), evidenced by a Promissory Note in that principal amount dated December 29, 2006 (the “Lydian Note”). The Lydian Loan bears interest at a floating rate of interest equal to the base rate on corporate loans posted by at least 75% of the nation’s largest banks, known as the “Wall Street Journal Prime,” which interest is payable monthly beginning on February 1, 2007. The maturity date of the Lydian Loan is July 1, 2008, at which time all outstanding principal and accrued but unpaid interest thereunder must be repaid to Lydian Private Bank.
As security for the Lydian Loan, Wyndcrest Baby Universe Holdings II, LLC, a Florida limited liability company, and Wyndcrest BabyUniverse Holdings III, LLC, a Florida limited liability company, each of which is controlled by Mr. Textor, pledged to Lydian Private Bank shares of our Common Stock held by them, which shares also serve as collateral under a loan previously extended to such pledgors by Lydian Private Bank. In addition, each such pledgor and Mr. Textor have executed a guaranty of the Lydian Loan in favor of Lydian Private Bank. The Lydian Loan Agreement and the Lydian Note contain customary events of default for facilities of this type; upon the occurrence of any such event of default, Lydian Private Bank shall be entitled to all rights and remedies available to it against the Company under law and the Lydian Loan Agreement and the Lydian Note, including, without limitation, the right to accelerate and demand immediate repayment of all sums due thereunder.
Director Independence
Information relating to the independence of the members of our Board of Directors is presented in Item 10 of this Annual Report on Form 10-K under the caption “Independence of the Board”, and is incorporated into this Item 13 by this reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Audit Fees
The aggregate fees billed by Singer Lewak Greenbaum & Goldstein LLP (“Singer Lewak”) for fiscal 2006 and 2005 for professional services rendered for the audit of our annual financial statements and for the review of the financial statements included in our Quarterly Reports on Form 10-Q or services that are normally provided in connection with statutory and regulatory filings or engagement for those fiscal years were $198,980 and $113,307, respectively.
Audit Related Fees
The aggregate fees billed by Singer Lewak for fiscal 2006 and 2005 for assurance and related services that are reasonably related to the performance of the audit or review of our financial statements, including the audit of financial statements related to acquisition candidates, and other than those services reported under “Audit Fees” above, for those fiscal years were $158,455 and $108,132, respectively.
Tax Fees
The aggregate fees billed by Singer Lewak for fiscal 2006 and 2005 for professional services rendered for tax compliance, tax advice and tax planning were $24,494 and $4,798, respectively.
All Other Fees
No fees were billed by Singer Lewak for fiscal 2006 and 2005, other than for the services described above under “Audit Fees,” “Audit Related Fees” and “Tax Fees”.
Pre-Approval Policies and Procedures for Audit and Permitted Non-Audit Services
The Audit Committee has a policy of considering and, if deemed appropriate, approving, on a case by case basis, any audit or permitted non-audit service proposed to be performed by Singer Lewak in advance of the performance of such service. These services may include audit services, audit-related services, tax services and other services. The Audit Committee has not implemented a policy or procedure which delegates the authority to approve, or pre-approve, audit or permitted non-audit services to be performed by Singer Lewak. In connection with making any pre-approval decision, the Audit Committee must consider whether the provision of such permitted non-audit services by Singer Lewak is consistent with maintaining Singer Lewak’s status as our independent auditors.
Consistent with these policies and procedures, the Audit Committee approved all of the services rendered by Singer Lewak during fiscal year 2006, as described above.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
Exhibit Number
Description
2.1
Asset Purchase Agreement, dated as of January 13, 2006, among Poshbaby, Inc., Posh Tots, L.L.C., Karen Booth Adams and Michael Dru Adams (incorporated by reference to Exhibit 2.1 to the Current Report on Form 8-K (File No. 001-32577) filed by BabyUniverse, Inc. on January 20, 2006
2.2
Asset Purchase Agreement, dated as of June 14, 2006, among Majestic Media, LLC, Grace Enterprises, L.L.C., and BabyUniverse, Inc. (incorporated by reference to Exhibit 2.1 to the Quarterly Report on Form 10-Q (File No. 001-32577) filed by BabyUniverse, Inc. on August 14, 2006
3.1
Form of Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 to the Registration Statement on Form S-1/A (Registration No. 333-124395) filed by BabyUniverse, Inc. on April 28, 2005)
3.2
Form of Amended Bylaws (incorporated by reference to Exhibit 3.2 to the Registration Statement on Form S-1/A (Registration No. 333-124395) filed by BabyUniverse, Inc. on April 28, 2005)
4.1
Specimen Common Stock certificate (incorporated by reference to Exhibit 4.1 to the Registration Statement on Form S-1/A (Registration No. 333-124395) filed by BabyUniverse, Inc. on July 13, 2005).
4.2
Amendment to Common Stock Purchase Warrant, dated as of May 11, 2006, between BabyUniverse, Inc. and GunnAllen Financial, Inc. (incorporated by reference to Exhibit 4.1 to the Quarterly Report on Form 10-Q (File No. 001-32577) filed by BabyUniverse, Inc. on May 15, 2006)
4.3
Senior Loan and Security Agreement, dated as of July 11, 2006, between BabyUniverse, Inc., and each of its subsidiaries, and Hercules Technology Growth Capital, Inc. (incorporated by reference to Exhibit 4.1 to the Current Report on Form 8-K (File No. 001-32577) filed by BabyUniverse, Inc. on July 14, 2006)
4.4
Warrant Agreement, dated as of July 11, 2006, between BabyUniverse, Inc. and Hercules Technology Growth Capital, Inc. (incorporated by reference to Exhibit 4.1 to the Current Report on Form 8-K (File No. 001-32577) filed by BabyUniverse, Inc. on July 14, 2006)
10.1
BabyUniverse, Inc. Stock Incentive Plan (incorporated by reference to Exhibit 10.1 to the Registration Statement on Form S-1/A (Registration No. 333-124395) filed by BabyUniverse, Inc. on April 28, 2005)
10.2
Loan Agreement, dated as of December 29, 2006, between BabyUniverse, Inc. and Lydian Private Bank (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K (File No. 001-32577) filed by BabyUniverse, Inc. on January 5, 2007)
10.3
Promissory Note, dated as of December 29, 2006, issued by BabyUniverse, Inc. to Lydian Private Bank (incorporated by reference to Exhibit 10.2 to the Current Report on Form 8-K (File No. 001-32577) filed by BabyUniverse, Inc. on January 5, 2007)
10.4
Employment Contract, dated as of January 13, 2006, between Poshbaby, Inc., and Karen Booth Adams (incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q (File No. 001-32577) filed by BabyUniverse, Inc. on May 15, 2006)
10.5
Employment Contract, dated as of January 13, 2006, between Poshbaby, Inc., and Andrea Edmunds (incorporated by reference to Exhibit 10.2 to the Quarterly Report on Form 10-Q (File No. 001-32577) filed by BabyUniverse, Inc. on May 15, 2006)
10.6
Employment Contract, dated as of January 13, 2006, between Poshbaby, Inc., and Susan Lindeman (incorporated by reference to Exhibit 10.3 to the Quarterly Report on Form 10-Q (File No. 001-32577) filed by BabyUniverse, Inc. on May 15, 2006)
10.7
Employment Contract, dated as of April 3, 2006, between BabyUniverse, Inc., and John Studdard (incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q (File No. 001-32577) filed by BabyUniverse, Inc. on August 14, 2006)
10.8
Amendment No. 1, dated as of November 10, 2006, to the Employment Agreement, dated as of April 1, 2005, between John C. Textor and BabyUniverse, Inc. (incorporated by reference to Exhibit 10.3 to the Quarterly Report on Form 10-Q (File No. 001-32577) filed by BabyUniverse, Inc. on November 14, 2006)
10.9
Amendment No. 1, dated as of November 10, 2006, to the Employment Agreement, dated as of April 1, 2005, between Jonathan Teaford and BabyUniverse, Inc. (incorporated by reference to Exhibit 10.4 to the Quarterly Report on Form 10-Q (File No. 001-32577) filed by BabyUniverse, Inc. on November 14, 2006)
10.10
Amendment No. 1, dated as of November 10, 2006, to the Employment Agreement, dated as of July 11, 2005, between Georgianne Brown and BabyUniverse, Inc. (incorporated by reference to Exhibit 10.5 to the Quarterly Report on Form 10-Q (File No. 001-32577) filed by BabyUniverse, Inc. on November 14, 2006)
10.11
Employment Contract, dated as of November 28, 2006, between BabyUniverse, Inc., and Michael R. Hull (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K (File No. 001-32577) filed by BabyUniverse, Inc. on December 4, 2006)
21.1
Subsidiaries of Registrant
23.1
Consent of Singer Lewak Greenbaum & Goldstein LLP, Independent Registered Public Accounting Firm
23.2
Consent of Lieberman & Associates, P.A., Independent Registered Public Accounting Firm
31.1
Certification by John C. Textor, Chief Executive Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification by Michael Hull, Chief Financial Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification by John C. Textor, Chief Executive Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2
Certification by Michael Hull, Chief Financial Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
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.
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.
Signature
Title
Date
/s/ JOHN C. TEXTOR
Chief Executive Officer (Principal Executive Officer)
April 2, 2007
and Chairman of the Board of Directors
John C. Textor
/s/ MICHAEL HULL
Chief Financial Officer
April 2, 2007
(Principal Financial and Accounting Officer)
Michael Hull
/s/ STUART GOFFMAN
Director
April 2, 2007
Stuart Goffman
/s/ JONATHAN TEAFORD
Executive Vice President and Director
April 2, 2007
Jonathan Teaford
/s/ CURTIS S. GIMSON
Director
April 2, 2007
Curtis S. Gimson
/s/ BETHEL G. GOTTLIEB
Director
April 2, 2007
Bethel G. Gottlieb
/s/ JOHN NICHOLS
Director
April 2, 2007
John Nichols
/s/ CARL STORK
Director
April 2, 2007
Carl Stork
BABYUNIVERSE, INC. AND SUBSIDIARIES
Report of Singer Lewak Greenbaum & Goldstein LLP, Independent Registered Public Accounting Firm
Report of Lieberman & Associates, P.A., Independent Registered Public Accounting Firm
Consolidated Balance Sheets - as of December 31, 2006 and 2005
Consolidated Statements of Operations - for the years ended December 31, 2006, 2005 and 2004
Consolidated Statements of Stockholders’ Equity (Deficit) - for the years ended December 31, 2006, 2005 and 2004
Consolidated Statements of Cash Flows - for the years ended December 31, 2006, 2005 and 2004
Notes to the Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
To the Board of Directors
BabyUniverse, Inc. and subsidiaries
Jupiter, Florida
We have audited the consolidated balance sheets of BabyUniverse, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity (deficit) and cash flows for each of the two years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements 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 BabyUniverse, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
SINGER LEWAK GREENBAUM & GOLDSTEIN, LLP
Los Angeles, California
March 31, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
BabyUniverse, Inc.
Ft. Lauderdale, Florida
We have audited the accompanying consolidated statements of operations, shareholder’s deficit and cash flows of BabyUniverse, Inc. for the year ended December 31, 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit 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 consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated statements of operations, shareholders’ deficit, and cash flows of BabyUniverse, Inc. for the year ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.
/s/ Lieberman & Associates, P.A.
Lieberman & Associates, P.A.
Ft. Lauderdale, Florida
June 13, 2005
BabyUniverse, Inc. and Subsidiaries
Consolidated Balance Sheets
The accompanying notes are an integral part of these consolidated financial statements.
BabyUniverse, Inc. and Subsidiaries
Consolidated Statements of Operations
The accompanying notes are an integral part of these consolidated financial statements.
BabyUniverse, Inc. and Subsidiaries
Consolidated Statements of Stockholders’ Equity (Deficit)
The accompanying notes are an integral part of these consolidated financial statements.
BabyUniverse, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
The accompanying notes are an integral part of these consolidated financial statements.
BabyUniverse, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
Note 1 - Description of the Company and Summary of Significant Accounting Policies
The Company
BabyUniverse, Inc. (the “Company’’) is a leading Internet content, commerce and new media company in the pregnancy, baby and toddler marketplace. Through its Web sites, BabyUniverse.com and DreamtimeBaby.com, the Company is a leading online retailer of brand-name baby, toddler and maternity products in the United States. Through its Web sites PoshTots.com and PoshLiving.com, the Company has extended its offerings in the baby and toddler market as a leading online provider of luxury furnishings to the country’s most affluent female consumers. Through PoshCravings.com, ePregnancy.com and the recently-introduced, BabyTV.com, the Company has also established a widely recognized platform for the delivery of content and new media resources to a national audience of expectant parents.
The Company was incorporated on October 15, 1997 under the laws of the State of Florida as Everything But The Baby, Inc. On November 16, 2001 the Board of Directors changed the name of the corporation to BabyUniverse, Inc. Customer purchases are shipped directly from the Company’s warehouses, or are drop shipped directly to customers from the Company’s suppliers. The Company operates on a calendar year basis.
On September 13, 2005 the Company acquired 100% of the outstanding capital stock of Huta Duna, Inc., d/b/a DreamtimeBaby.com (“Dreamtime Baby”). The results of Dreamtime Baby’s operations have been included in the consolidated financial statements of the Company since that date.
On January 13, 2006 the Company acquired, through a newly-created wholly-owned subsidiary, substantially all of the assets of PoshTots, LLC, a luxury online retailer of baby and children’s furnishings. Through its primary website, www.PoshTots.com, the Richmond-based PoshTots, LLC has long been recognized as a leading online retailer of high-end, artisan-crafted furniture to this country’s most affluent new mothers. Beyond the baby and children’s segments, PoshTots recently extended its brand with the Fall 2005 introduction of a new website, www.PoshLiving.com, offering designer quality home furnishings to its existing and growing base of affluent, predominantly female, customers. In March 2006, Posh Tots introduced another new website, www.PoshCravings.com, designed as a content driven initiative targeted at the affluent female customer base already developed by Posh Tots.
Principles of Consolidation
The Company’s consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of the Company and its wholly-owned subsidiaries. All material inter-company transactions and balances have been eliminated in consolidation.
Reclassifications
Certain account balances in the prior year have been reclassified to permit comparison with the current year.
Use of Estimates
Our consolidated financial statements have been prepared in accordance with GAAP. The preparation of these financial statements requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. The Company bases its estimates on historical experience and on other assumptions that it believes to be reasonable under the circumstances. However, estimates inherently relate to matters that are uncertain at the time the estimates are made, and are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments, or conditions.
Concentration of Credit Risk
The Company’s financial instruments that are exposed to concentration of credit risk are cash. Additionally, the Company maintains cash balances in bank deposit and money market accounts that, at times, may exceed federally insured limits.
Cash
The Company considers cash in banks, commercial paper and other highly liquid investments with insignificant interest rate risk and maturities of three months or less at the time of acquisition to be cash and cash equivalents. The Company’s cash balance as of December 31, 2006 includes $260,000 held by a commercial bank in a certificate of deposit in support of the bank’s $250,000 purchase card credit facility extended to the Company. At December 31, 2006, the Company had cash of approximately $3.5 million.
Accounts Receivable
The Company’s accounts receivable consist primarily of cash due from credit card companies for orders fulfilled prior to the receipt of funds. No allowance for doubtful accounts has been provided as of December 31, 2006 or 2005.
Inventory
Inventory, which consists primarily of car seats, strollers, bedding, baby toys, learning tools and other small items available for sale, is accounted for using the first-in first-out (“FIFO”) method, and is valued at the lower of cost or market value. This valuation requires the Company to make judgments, based on currently-available information, about the likely method of disposition, such as sales to individual customers, returns to product vendors, or liquidations, and expected recoverable values of each method of disposition. As of December 31, 2006, the Company has provided a reserve for inventory obsolescence of $49,000. There was no reserve for obsolescence at December 31, 2005.
Prepaid Expenses
Prepaid expenses include amounts paid in advance for Directors and Officers liability insurance, acquisition costs and public offering costs.
Fixed Assets
Fixed assets are stated at historical cost. Depreciation and amortization are computed using the straight line method over the estimated useful life of the asset. Leasehold improvements are amortized over the term of their estimated useful lives or the related leases, whichever is shorter.
The Company capitalizes certain costs incurred in connection with the development of or obtaining internal use software in accordance with Statement of Position (SOP) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, and Emerging Issues Task Force (“EITF”) 00-2, Accounting for Web Site Development Costs.
Long-Lived Assets
The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recovered. The Company looks primarily to the undiscounted future cash flows in its assessment of whether or not long-lived assets have been impaired. At December 31, 2006 and December 31, 2005 the Company determined there was no impairment.
Deposits
Deposits consist of security deposits for the lease of the Company’s office and warehouse facilities.
Goodwill
SFAS No. 141, Business Combinations, requires that all business combinations be accounted for using the purchase method of accounting and that certain intangible assets acquired in a business combination be recognized as assets separate from goodwill. Goodwill is not subject to amortization and is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset may be impaired in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. The impairment test consists of a comparison of the fair value of the reporting unit with its carrying amount. If the carrying amount of the reporting unit exceeds its fair value, then an analysis will be performed to compare the implied fair value with the carrying amount of goodwill. An impairment loss would be recognized in an amount equal to the difference. Fair value is generally based upon future cash flows discounted at a rate that reflects the risk involved or market-based comparables. After an impairment loss is recognized, the adjusted carrying amount of goodwill becomes its new accounting basis.
Gift Certificate Liability
The Company sells gift certificates to be exchanged for merchandise at the discretion of the certificate holder. Management has determined that certificates over one year old, generally, are not redeemed. Certificates of less than one year are recorded as a current liability on the Company’s Consolidated Balance Sheet. Based on historical data, Management has determined that the dollar value of certificates redeemed, whose age is greater than one year, is immaterial to total revenue.
Deferred Revenue
Deferred revenue represents payments received from customers before products are shipped.
Revenue Recognition
The Company has adopted SEC Staff Accounting Bulletin (SAB) No. 101 - Revenue Recognition, which defines that revenue is both earned and realizable when the following four conditions are met:
•
Pervasive evidence of an arrangement exists
•
The selling price is fixed or determinable
•
Delivery or performance has occurred
•
Collectibility is reasonably assured
Per SEC Staff Accounting Bulletin (SAB) No. 104 , which further clarifies SAB No. 101, if merchandise is shipped to customers F.O.B. Shipping Point, title is considered to have transferred to the customer at the time the merchandise is delivered to the carrier. The Company’s policy is to ship F.O.B. Shipping Point from its warehouses and drop ship locations, and therefore delivery is deemed to have occurred at time of shipment.
The Company has also adopted EITF 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, as its formal guidelines for the recognition of revenue in its financial statements. All sales are completed through the Company and liability for product purchases is paid by the Company. Therefore, the Company recognizes the gross sales price as its revenue at the time that the product is delivered to the carrier.
Return allowances, which reduce product revenue, are estimated using historical experience.
Cost of Goods Sold
Cost of goods sold consists of the purchase price of the Company’s products that were sold, inbound and outbound shipping costs, and purchase discounts and credits that the Company earned.
Advertising
The Company’s marketing consists primarily of online advertising with a number of Internet providers, which includes portal advertising, search engine marketing and other programs designed to educate customers about the Company’s brands and products. All advertising costs are expensed as incurred.
Technology
Technology costs are expensed as incurred, except in those circumstances where the costs are related to the development of internal use software and website development. Per SOP 98-1 these costs are capitalized and depreciated over a 5-year period. During 2006, 2005 and 2004 the Company capitalized costs of approximately $205,388, $168,000 and $172,000, respectively.
Share-Based Compensation
Effective with the Company’s current fiscal year that began on January 1, 2006, the Company adopted the accounting and disclosure provisions of Statement of Financial Accounting Standard SFAS No. 123(R), Share-Based Payment, which requires that new, modified and unvested share based payment transactions with employees, such as stock options and restricted stock, be measured at fair value and recognized as compensation expense over the vesting period.
The Company adopted SFAS No. 123(R) using the modified prospective application transition method. Under that transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards at the date of adoption, for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS No. 123, Accounting for Stock-Based Compensation, for either recognition or pro forma disclosures. As part of adopting the modified prospective approach during the transitional period, the Company considered the determination of a one-time cumulative effect adjustment for the portion of stock options granted prior to January 1, 2006 that had not vested. However, as of January 1, 2006, no cumulative effect adjustment was required, because the requisite service had previously been fully rendered for outstanding awards, and because the Company accounted for the Plan under Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, instead of SFAS No. 123.
Prior to January 1, 2006, the Company had accounted for the Plan under APB Opinion No. 25 and its related interpretations, and adopted the disclosure provisions of SFAS No. 123, as amended by SFAS No. 148, Accounting For Stock-Based Compensation - Transition and Disclosure. SFAS No. 123 defines a fair value method of accounting for issuance of stock options and other equity instruments. Under the fair value method, compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period, which is usually the vesting period. Pursuant to SFAS No. 123, companies were encouraged, but not required to adopt the fair value method of accounting for employee stock based transactions. Companies were also permitted to continue to account for such transactions under Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, but were required to disclose in a note to the financial statements pro forma results as if the Company had applied SFAS No. 123.
At December 31, 2005, the Company had a fixed stock option plan. The Company applied APB Opinion No. 25 and related Interpretations in accounting for its plan. Had compensation cost for the Company’s stock option plan been determined based on the fair value at the grant dates for awards under that plan consistent with the method of SFAS No. 123, the Company’s net income (loss) and earnings (loss) per share would have been reduced to the pro forma amounts indicated below:
For purposes of the pro forma disclosure above, the fair value of each option grant was estimated on the date of grant using the Minimum Value method prescribed for use by non-public companies pursuant to SFAS No. 123. The following assumptions were used in applying the Minimum Value method for 2004: no dividend yield; no volatility factor; risk-free interest rates for that ranged between 3.05% and 3.14%; and expected lives using the “simplified method” permitted by the SEC’s Staff Accounting Bulletin 107, issued March 29, 2005. For 2006 and 2005, the Company used an acceptable valuation method prescribed for use by public companies pursuant to SFAS No. 123. The following assumptions were used in 2006 and 2005, respectively, applying the fair value method: no dividend yield; volatility factor of 56% and 70%; risk-free interest rates that ranged between 3.69% and 4.46%; and expected lives using the “simplified method” permitted by the SEC’s Staff Accounting Bulletin 107.
During the initial phase-in period, the effects of applying this SFAS No. 123 for the purpose of disclosing the pro forma effect on net income (loss) and earnings (loss) per share as reported are not likely to be representative of the effects on reported net income (loss) for future years, because options vest over several years and additional awards are generally made each year, and because the Company no longer used the Minimum Value method after 2004.
The Company’s 2001 Stock Award Plan was amended in April 2005 by our board of directors and shareholders and was renamed the “BabyUniverse 2005 Stock Incentive Plan.” Under the Stock Incentive Plan, the exercise price of each option equals the market price of the stock on the date of grant, the vesting period generally ranges between two and five years, and an option’s maximum term is 10 years.
On April 27, 2005, the Board of Directors approved the acceleration of vesting of all unvested options. A total of 208,496 stock options with an average exercise price of $ 2.60 and an average remaining contractual life of 18 months were subject to acceleration. The exercise price and number of shares subject to acceleration were unchanged.
As of December 31, 2006, an aggregate of 405,289 shares of common stock are reserved for issuance under the 2005 Stock Incentive Plan. Restricted stock grants and stock option grants were outstanding for an aggregate of 234,054 shares of stock, and 171,235 shares remained available for grant. In addition, there were outstanding options to purchase a total of 104,248 shares of our common stock, and 20,000 shares of restricted stock, which were granted outside of the 2005 Stock Incentive Plan. Shares issued pursuant to the Stock Incentive Plan will be newly-issued and authorized shares of common stock, or treasury shares.
Income Taxes
The Financial Accounting Standards Board (FASB) issued Statements of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes, which requires companies to use the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred income taxes are recognized for the tax consequence of temporary differences by applying enacted statutory tax rates applicable to future year’s differences between the financial statements carrying amounts and the tax basis of existing assets and liabilities. Pursuant to SFAS No. 109, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Under the deferred method, deferred taxes were recognized using the tax applicable to the year of the calculation and were not adjusted for subsequent changes in tax rates.
Earnings (Loss) per Share
The Company computes earnings (loss) per share in accordance with the provisions of SFAS No. 128, Earnings per Share. Under the provisions of SFAS No. 128, basic earnings per share (EPS) is computed by dividing the net earnings (loss) from operations for the period by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur from common stock issuable through stock based compensation including stock options, restricted stock awards, warrants and other convertible securities.
For years ending December 31, 2006 and 2005 the Company reported a net loss. The diluted earnings per share is not presented for those periods since the effect is antidilutive.
Fair Value of Financial Instruments
The carrying amounts of financial instruments including cash, accounts receivable, accounts payable and accrued expenses approximate fair value as of December 31, 2006 and 2005, as a result of the relatively short maturity of these instruments. Notes and capital leases are reflected at fair value and are recorded net of the unamortized discount.
Recently Issued Accounting Standards
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments-an amendment of FASB Statements No. 133 and 140. This Statement amends FASB Statements No. 133, Accounting for Derivative Instruments and Hedging Activities, and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This Statement resolves issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” This Statement:
a.
Permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation
b.
Clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133
c.
Establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation
d.
Clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives
e.
Amends Statement 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.
This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Management does not expect adoption of SFAS No. 155 to have a material impact, if any, on the Company’s financial position or results of operations.
In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets an amendment of FASB Statement No. 140. This Statement amends FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, with respect to the accounting for separately recognized servicing assets and servicing liabilities. This Statement:
a.
Requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract.
b.
Requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable.
c.
Permits an entity to choose either the amortization method or the fair value measurement method for subsequent measurement for each class of separately recognized servicing assets and liabilities.
d.
At its initial adoption, permits a one-time reclassification of available-for-sale securities to trading securities by entities with recognized servicing rights, without calling into question the treatment of other available-for-sale securities under Statement No. 115.
e.
Requires separate presentation of servicing assets and liabilities subsequently measured at fair value in the statement of financial position and additional disclosures.
An entity should adopt this Statement as of the beginning of its first fiscal year that begins after September 15, 2006. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including interim financial statements, for any period of that fiscal year. The effective date of this Statement is the date an entity adopts the requirements of this Statement. The adoption of this statement is not expected to have a material impact on the Company’s consolidated financial statements.
In June 2006, the Emerging Issues Task Force (“EITF”) issued EITF 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the income statement (That is, Gross versus Net Presentation)” to clarify diversity in practice on the presentation of different types of taxes in the financial statements. The Task Force concluded that, for taxes within the scope of the issue, a company may adopt a policy of presenting taxes either gross within revenue or net. That is, it may include charges to customers for taxes within revenues and the charge for the taxes from the taxing authority within cost of sales, or, alternatively, it may net the charge to the customer and the charge from the taxing authority. If taxes subject to EITF 06-3 are significant, a company is required to disclose its accounting policy for presenting taxes and the amounts of such taxes that are recognized on a gross basis. The guidance in this consensus is effective for the first interim reporting period beginning after December 15, 2006 (the first quarter of our fiscal year 2007). We do not expect the adoption of EITF 06-3 will have a material impact on our consolidated results of operations, financial position or cash flow.
In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109. This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. Earlier application of the provisions of this Interpretation is encouraged if the enterprise has not yet issued financial statements, including interim financial statements, in the period this Interpretation is adopted. Management does not expect adoption of Interpretation No. 48 to have a material impact, if any, on the Company’s consolidated financial position or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines the fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Early adoption is encouraged, provided that we have not yet issued financial statements for that fiscal year, including any financial statements for an interim period within that fiscal year. We are currently evaluating the impact SFAS 157 may have on our consolidated financial condition or results of operations.
In September 2006, the United States Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). This SAB provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB 108 establishes an approach that requires quantification of financial statement errors based on the effects of each of the company’s balance sheet and statement of operations and the related financial statement disclosures. The SAB permits existing public companies to record the cumulative effect of initially applying this approach in the first year ending after November 15, 2006 by recording the necessary correcting adjustments to the carrying values of assets and liabilities as of the beginning of that year with the offsetting adjustment recorded to the opening balance of retained earnings. Additionally, the use of the cumulative effect transition method requires detailed disclosure of the nature and amount of each individual error being corrected through the cumulative adjustment and how and when it arose. We are currently evaluating the impact SAB 108 may have to our consolidated financial condition or results of operations.
In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106, and 132(R). This Statement improves financial reporting by requiring an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income of a business entity or changes in unrestricted net assets of a not-for-profit organization. This Statement also improves financial reporting by requiring an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. An employer with publicly traded equity securities is required to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006. Earlier application of the recognition or measurement date provisions is encouraged; however, early application must be for all of an employer’s benefit plans. Retrospective application of this Statement is not permitted. Management does not expect adoption of SFAS No. 158 to have a material impact, if any, on the Company’s consolidated financial position or results of operations.
Note 2 - Acquisitions
ePregnancy
On June 15, 2006, the Company acquired certain assets related specifically to the business of ePregnancy.com and ePregnancy Magazine. The selected assets acquired include the URL www.ePregnancy.com, the ePregnancy trademark, a related online community website, message boards, and an expansive archive of content. The magazine’s prior owners discontinued publication of ePregnancy Magazine and the final published issue was distributed in late April as the May 2006 issue. BabyUniverse intends to focus its efforts on growing and supporting the online community at ePregnancy.com and does not intend to revive the magazine.
The revenue-producing activity of the business component did not exist at the time selected assets were acquired by the Company. In addition, none of the following attributes were included among the selected assets acquired by the Company: physical facilities, employee base, sales force or production techniques. As a result of these facts, the Company has accounted for the ePregnancy transaction as an acquisition of selected assets, and not as the acquisition of a business, consistent with guidance provided in Rule 11-01 (d) of Regulation S-X of the Securities and Exchange Commission.
Posh Tots
On January 13, 2006 BabyUniverse completed an acquisition of substantially all of the assets of Posh Tots, LLC (“Posh Tots”). The acquisition was consummated pursuant to the terms and provisions of an Asset Purchase Agreement dated as of January 13, 2006 by and between Posh Tots, Inc., a wholly owned subsidiary of the Company, and Posh Tots.
In connection with the acquisition, the Company issued a promissory note, as adjusted, of $5,570,981, and paid $6,000,000 in cash. In addition, the Company issued 237,248 shares of the Company’s common stock and warrants to purchase 110,000 shares of common stock. The shares were valued at the date of acquisition and resulted in a value of $2,014,236. The warrants are exercisable at $8.10 per share, have a contractual life of two years, and vest one year following the acquisition date. The warrants were valued at $300,753 using the Black-Scholes option pricing model with the following assumptions: a risk-free interest rate of 4.23%, a volatility factor of 56%, and an expected term of two years.
Approximately $600,000 of the purchase price, related to repayment of the promissory note, was deposited into an escrow fund to secure possible claims related to the representations and warranties. The escrow fund was subsequently distributed to the seller in August 2006, net of a post-closing working capital adjustment pursuant to the agreement. The difference between the purchase price and the fair value of the acquired net assets of Posh Tots of $12,071,917 was recorded as goodwill.
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition, January 13, 2006:
Of the $2,660,000 of acquired intangible assets, $2,200,000 was assigned to the Posh Tots trade name that has an indefinite life, $200,000 was assigned to customer list that has a useful life of 4 years, and $260,000 was assigned to catalogue and website content that has a useful life of 3 years.
The accompanying unaudited pro forma summary represents consolidated results of operations for BabyUniverse as if the acquisition of Posh Tots had been consummated on January 1, 2005. Certain pro forma adjustments were reflected in the consolidated results of operations as follows:
1.
To reflect members’ salaries on a “going-forward” basis as agreed to in employment contracts entered into by Posh Tots, Inc. and three former members of Posh Tots, LLC. The employment contracts specify annual cash-based compensation of $360,000. The adjustment decreased actual members’ salaries to the contracted amounts.
2.
To reflect the accumulated amortization and related amortization expense of certain intangible assets that were created in connection with the acquisition of Posh Tots assets.
3.
The federal income tax effect has been omitted because BabyUniverse believes it can apply its net operating loss carryforwards to profits generated. However, the pro forma income of Posh Tots, LLC would be subject to Virginia state income tax. BabyUniverse’s Florida state net operating loss carryforwards would not be applicable to Virginia state income. The applicable 2005 Virginia state tax rate of six percent has been applied to the Virginia pro forma income.
The pro forma information does not necessarily reflect the actual results that would have been achieved, nor is it necessarily indicative of future consolidated results of the Company.
DreamtimeBaby.com
On September 13, 2005 BabyUniverse, Inc. acquired 100 percent of the outstanding common shares of privately-held Huta Duna, Inc. The results of Huta Duna, Inc.’s operations have been included in the consolidated financial statements of the Company since that date. Huta Duna, Inc. operates an e-commerce web site, DreamTimeBaby.com, an online retailer of brand name baby products. Dreamtime Baby offers a broad selection of baby products, but it is primarily recognized for its focus on high quality baby bedding products. As a result of the acquisition, BabyUniverse expects to benefit from Dreamtime Baby’s strong internet marketing practices and strong supplier relationships. BabyUniverse also expects to reduce purchasing and shipping costs through economies of scale.
The aggregate purchase price paid by BabyUniverse, inclusive of closing costs of approximately $206,226, was $7,096,871, including $6,399,400 of cash and 53,165 shares of BabyUniverse common stock with a fair value of $491,245. The fair value of the 53,165 common shares issued was determined based on the 15-day closing price of BabyUniverse’s common stock as reported by the American Stock Exchange for the seven days prior to, the day of and the seven days following the acquisition date, which date coincided with the agreement and announcement of the transaction. Approximately $650,000 of the purchase price was deposited into an escrow fund to secure possible claims related to the representations and warranties. The escrow fund is eligible for release after twelve months. The difference between the purchase price and the fair value of the acquired net assets of Dreamtime Baby of $6,620,057 was recorded as goodwill.
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition, September 13, 2005:
Of the $190,000 of acquired intangible assets, $140,000 was assigned to the Dreamtime Baby trade name that is being amortized over five years, and $50,000 was assigned to a non-competition agreement. The non-competition agreement has a useful life of 3 years. Of the $6,620,057 of goodwill, none is expected to be deductible for tax purposes.
The amortization expense relating to the acquired intangible assets has no associated tax impact since the acquisition of Dreamtime Baby was a stock purchase and any acquired intangible assets would not be deductible for tax purposes.
The accompanying unaudited pro forma summary represents consolidated results of operations for BabyUniverse as if the acquisition of Dreamtime Baby had been consummated on January 1, 2004. Certain pro forma adjustments were reflected in the consolidated results of operations as follows:
•
Selling, general and administrative expenses (“SGA”) were adjusted to reflect Dreamtime Baby’s officer’s salary on a “going-forward” basis as agreed to in an employment contract entered into by BabyUniverse and the former stockholder of Dreamtime Baby.
•
The amortization expense of certain intangible assets that were created in connection with the acquisition of Dreamtime Baby was reflected as if the acquisition had occurred on January 1, 2004.
•
The weighted average shares outstanding used to compute earnings per share were increased to reflect the 53,165 shares issued as part of the aggregate purchase price as well as the shares sold in the Company’s initial public offering. The tax effect has been omitted because BabyUniverse believes it can apply its net operating loss carryforwards to profits generated.
The unaudited pro forma information does not necessarily reflect the actual results that would have been achieved, nor is it necessarily indicative of future consolidated results of BabyUniverse.
Note 3 - Inventory
Inventory, which consists primarily of car seats, strollers, bedding, furniture, baby toys, learning tools and other small items available for sale, is accounted for using the first-in first-out (“FIFO”) method and is valued at the lower of cost or market value. This valuation requires the Company to make judgments, based on currently-available information, about the likely method of disposition, such as sales to individual customers, returns to product vendors, or liquidations, and expected recoverable values of each method of disposition. Reserves for obsolescence at December 31, 2006 and 2005 amounted to $49,000 and $0, respectively.
We generally own and hold only a portion of the inventory needed to support our level of sales. Although we have continued to increase inventory of those items with lower risk based on higher demand and turnover, a significant portion of the products we offer is owned by our suppliers. This enables us to reduce some of the cost and risk associated with carrying a full inventory of the products we sell. Upon receipt of a customer order for a specific product that will be drop-shipped from a supplier, we simultaneously purchase that product from our supplier, who ships it directly to our customer. Since our inception, our business model has minimized inventory risk by maximizing the numbers of products we sell that are owned by others.
Note 4 - Goodwill
Intangible assets with indefinite lives and goodwill are not amortized, but are tested at least annually for impairment, or if circumstances change that will more likely than not reduce the fair value of the reporting unit below its carrying amount.
On January 13, 2006, BabyUniverse acquired Posh Tots (See Note 2 - Acquisitions). The following table sets forth goodwill, net, as of December 31, 2005 and 2006:
During 2006, the Company recognized additional adjustments to the DreamtimeBaby goodwill of $140,067. These adjustments resulted from additional transaction costs for the DreamtimeBaby acquisition of approximately $43,000, as well as a settlement with the seller that reduced the post-closing working capital adjustment by $97,000. The Company also recognized an additional adjustment during 2006 to the Posh Tots goodwill resulting from a settlement with the seller that reduced the post-closing working capital adjustment by $142,705.
Note 5 - Intangible Assets
BabyUniverse reviews for the impairment of identifiable intangible assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets, and SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.
Identifiable intangible assets are amortized under the straight-line method over the period of expected benefit ranging from three to five years, unless they were determined to be subject to indefinite lives. The following table sets forth the components of intangible assets as of December 31, 2006:
Amortization expense for the twelve month period ended December 31, 2006 was $209,602. Estimated amortization expense for the twelve months ending December 31 is as follows:
Note 6 - Fixed Assets
Fixed assets are stated at cost less accumulated depreciation and amortization. Expenditures for ordinary maintenance and repairs are charged to operations as incurred. Major additions and improvements are capitalized using the straight-line method over the estimated useful life of the asset. The Company has elected to capitalize outside development costs related to the development of its software following the guidelines of the AICPA’s Statement of Position (SOP) 98-1 which states that application and development cost associated with the purchase or development of software that is for the internal use of a company, shall be capitalized and depreciated over the estimated useful life of the software.
All of the Company’s fixed assets have been pledged as security for the Hercules Technology note payable, see Note 8.
Note 7 - Accounts Payable and Accrued Expenses
Accounts payable and accrued expenses consist of the following:
Note 8 - Notes and Capital Lease Payables
Notes and capital leases outstanding at December 31, 2006 and 2005 were as follows:
Hercules Note
On July 11, 2006, the Company completed a $5.0 million debt financing transaction with Hercules Technology Growth Capital, Inc. Proceeds from the financing were used primarily to refinance the Company’s existing debt, thereby enabling the Company to realize a negotiated $1.5 million discount on the $6.0 million note. The pre-payment and principal reduction in the note payable of $1.5 million was recognized in other income and expense as a gain on early extinguishment of debt in accordance with the accounting treatment prescribed by Accounting Principles Board Opinion 26, Early Extinguishment of Debt, and SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. The Company previously stated in its Form 10-Q for the quarter ended June 30, 2006 (Note 9 - Subsequent Event) that, “The pre-payment and principal reduction in the note payable subsequent to June 30, 2006 will reduce the Company’s goodwill amount related to the Posh Tots acquisition by $1.5 million.” This initial determination as to the proposed accounting treatment was based on limited consideration at that time of the relevant accounting pronouncements applicable to the underlying facts of this transaction. Based on subsequent review and consideration, the Company believes that SFAS 141, “Business Combinations”, is not relevant to the essential facts of this transaction.
The Senior Loan and Agreement (“Loan” or “Loan Agreement”) is for a term of 36 months, at an interest rate equal to the prime interest rate plus 2.35%. The Loan Agreement allows for interest-only payments for 12 months, with principal and interest payments due monthly thereafter. The interest-only period and the term of the Loan may be extended up to six months based on meeting certain financial tests. The Loan is secured by a perfected first priority security interest in all of the Company’s tangible and intangible assets and requires compliance with certain financial covenants, including a current ratio requirement, by which the Company must maintain a current ratio of at least .85 for the quarter ending September 30, 2006, at least .90 for the quarter ending December 31, 2006, and at least 1.0 for each subsequent calendar quarter thereafter. The Company was in compliance with all covenants as of December 31, 2006. (See PART II, OTHER INFORMATION - Item 1A., Risk Factors, for further information.)
In conjunction with the Loan Agreement, the Company issued a warrant to Hercules Technology Growth Capital, Inc. to purchase 91,912 shares of common stock of the Company at an exercise price of $8.16 per share. The warrant vested immediately upon execution of the Loan Agreement and is exercisable for seven years. The Company has evaluated the warrants under the provisions of EITF 00-19 and has determined that it qualifies for equity treatment. Therefore, the pro-rata fair value of the warrant as of July 11, 2006 of $333,034 was classified as debt discount and is being amortized over the 36-month term of the Loan in accordance with Accounting Principles Board Opinion No. 14.
Lydian Note
On December 29, 2006, BabyUniverse, Inc. entered into a Loan Agreement (the “Lydian Loan Agreement”) with Lydian Private Bank, pursuant to which Lydian Private Bank provided a term loan of $2,000,000 to the Company (the “Lydian Loan”), evidenced by a Promissory Note in that principal amount dated December 29, 2006 (the “Lydian Note”). The Lydian Loan bears interest at a floating rate of interest equal to the base rate on corporate loans posted by at least 75% of the nation’s largest banks, known as the “Wall Street Journal Prime,” which interest is payable monthly beginning on February 1, 2007. The maturity date of the Lydian Loan is July 1, 2008, at which time all outstanding principal and accrued but unpaid interest thereunder must be repaid to Lydian Private Bank.
As security for the Lydian Loan, Wyndcrest BabyUniverse Holdings II, LLC, a Florida limited liability company, and Wyndcrest BabyUniverse Holdings III, LLC, a Florida limited liability company, each of which is controlled by John C. Textor, the Company’s Chairman and Chief Executive Officer, pledged to Lydian Private Bank shares of the Company’s Common Stock held by them, which shares also serve as collateral under a loan previously extended to such pledgors by Lydian Private Bank. In addition, each such pledgor and Mr. Textor have executed a guaranty of the Lydian Loan in favor of Lydian Private Bank. The Lydian Loan Agreement and the Lydian Note contain customary events of default for facilities of this type; upon the occurrence of any such event of default, Lydian Private Bank shall be entitled to all rights and remedies available to it against the Company under law and the Lydian Loan Agreement and the Lydian Note, including, without limitation, the right to accelerate and demand immediate repayment of all sums due thereunder.
Note 9 - Stockholders’ Equity (Deficit)
In October 2004 the Board of Directors authorized the grant of options to purchase 156,372 shares of common stock to three members of the Board of Advisors. One-third of the options vests 4 months from the grant date and the balance vests in equal shares on the following two anniversaries of the grant date. On April 27, 2005 the vesting of all options were accelerated. The options must be exercised within ten years from the grant date. The exercise price of each option is $1.27 per share.
On January 18, 2005, the Board of Directors authorized the grant of options to purchase 52,124 shares of common stock to a member of the Board of Directors. One-third of the options vested 4 months from the grant date and the balance vests in equal shares on the following two anniversaries of the grant date. On April 27, 2005 the vesting of all options were accelerated. The options must be exercised within ten years from the grant date. The exercise price of each option is $6.25 per share.
On April 27, 2005, the holders of approximately 72% of the Company’s then-issued and outstanding common stock, by majority written consent in lieu of a meeting of shareholders, authorized a 525:1 stock split and accompanying amendment to the Company’s amended and restated articles of incorporation. On July 12, 2005, the holders of approximately 78% of the Company’s then-issued and outstanding common stock, by majority written consent in lieu of a meeting of shareholders, authorized a 19:18 stock split and accompanying amendment to the Company’s amended and restated articles of incorporation. All references to numbers of shares in the accompanying financial statements and notes have been adjusted to give retroactive effect to these stock splits.
During 2005, the Board of Directors authorized the grant to three employees and two directors of 177,221 shares of restricted, nonvested stock, with vesting periods ranging between two and four years, in consideration of future services to be rendered to the Company. Unearned compensation of $619,528 was recorded based on the fair values at the dates of grant, and compensation expense is recognized during the vesting periods. Stock-based compensation of $65,842 related to the restricted stock grants was recorded during 2005.
On August 2, 2005, the Company’s Registration Statement on Form S-1 was declared effective for its initial public offering, pursuant to which the Company sold two million shares of common stock at $9.50 per share. The Company’s common stock commenced trading on August 3, 2005. The offering closed on August 8, 2005, and the Company received net proceeds of approximately $16.3 million (after payments to underwriters of $1.9 million, issuance of 130,000 warrants and additional estimated offering expenses of $757,000).
The warrant to purchase 130,000 shares of the Company’s common stock is initially exercisable by the underwriters on or after February 5, 2006 and until the close of business on August 2, 2010 at a purchase price of $11.875 per share. The holders may require the Company to convert the value of this warrant into shares of common stock through a cashless exercise option, in lieu of the payment by the holders of the exercise price. The value of the cashless exercise option would be determined by the excess of the current market price on the exercise date over the exercise price of the shares of common stock. The value so determined would be converted to equivalent shares of common stock by dividing it by the current market price of the common stock on the exercise date. The warrant also contains certain anti-dilution privileges for stock splits, acquisitions, and other restructurings; allows the holder at any time after the exercise date to request the company to file a registration statement for the underlying shares and perform certain other registration related activities as required; provides for certain payments to the holder in the event of delays with respect to the filing of a requested registration statement; and entitles the holder to unlimited “piggyback” registration rights. The Company has evaluated the warrants under the provisions of EITF 00-19 and has determined that it qualifies for equity treatment.
On October 1, 2005, the Company granted 7,500 restricted, non-vested shares to an investor relations firm pursuant to a services agreement dated October 1, 2005. The shares were issued subject to a termination clause in favor of the Company stating that they were unvested and refundable to the Company until January 1, 2006, at which time, the services agreement had not been terminated by the Company, and the shares became fully vested.
On January 13, 2006, we granted options to purchase 50,000 shares of common stock to officers of Posh Tots LLC in connection with the Company’s purchase of the assets of Posh Tots LLC. These options bore an exercise price of $8.10, the closing price on the date of the grant, vested over a two year period and were toexpire after 25 months. Subsequent to January 13, 2006, 30,000 options were cancelled in connection with one officer terminating employment with the Company.
On January 13, 2006, we granted options to purchase 75,000 shares of common stock to employees of Posh Tots LLC in connection with the Company’s purchase of the assets of Posh Tots LLC. These options bore an exercise price of $8.10, the closing price on the date of the grant, vested over a three year period and expire after 37 months. Subsequent to January 13, 2006, 15,000 options were cancelled in connection three employees terminating employment with the Company.
On April 3, 2006, the Company granted options to purchase 50,000 shares of common stock to a key employee related to the development and implementation of the BabyTV new media concept. These options bear an exercise price of $9.86, the closing price on the date of the grant, vest quarterly over a four year period and expire after 48 months.
On November 16, 2006, the Company granted options to purchase 2,000 shares of common stock, to an employee. These options bear an exercise price of $6.84, the closing price on the date of the grant, 500 options vested immediately, and the remaining shares vest over two years. These options expire in 25 months.
On December 11, 2006, the Company granted 25,000 restricted shares of the Company’s common stock to an employee. These shares vest over a four year period.
Note 10 - Operational Reorganization and Restructuring
During the first quarter of 2006, the Company initiated a multi-faceted reorganization and restructuring plan (the “Plan”), which was essentially completed during the second quarter of 2006. The objectives of the Plan were to (1) integrate the business operations of two recent acquisitions with the BabyUniverse e-commerce business in order to achieve greater efficiency, and (2) benefit from certain business strengths and best practices of the acquired organizations. The Plan was comprised of the following specific elements:
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Open the Company’s new distribution center in 23,000 square feet of leased space in Las Vegas in January 2006.
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Implement a new warehouse management system for the Las Vegas distribution center by late March 2006.
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Relocate DreamtimeBaby’s business operations and inventory from its Los Angeles-area headquarters to the Las Vegas distribution center by late March 2006.
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Relocate the BabyUniverse inventory and distribution activities from its Fort Lauderdale warehouse to the Las Vegas distribution center during February 2006.
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Restructure the BabyUniverse e-commerce business operations by consolidating certain activities within the Posh Tots’ management organization in Richmond during May 2006.
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Reorganize and consolidate the senior management organization in corporate offices in Jupiter, Florida during June 2006. The corporate offices house the Company’s executive management organization and certain corporate services including strategic planning, finance, technology, logistics and new media development.
The restructuring expenses related to the Plan were accounted for pursuant to Statement of Financial Accounting Standard No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses exit or disposal activities including one-time involuntary employee termination benefits, contract termination costs and costs to consolidate facilities or relocate employees. The total expense incurred for restructuring activities was approximately $506,000, of which $116,000 and $390,000 were recognized during the first and second quarters of 2006, respectively.
The major costs associated with implementing the plan were as follows:
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One-time termination benefits were provided to certain current employees that were involuntarily terminated pursuant to the Plan, which was announced in February. The affected employees were required to render service through various dates to June 30, 2006 in order to receive the termination benefits. The total expense incurred for one-time termination benefits was approximately $111,000. Approximately $43,000 and $68,000 of one-time termination benefits were recognized as restructuring expenses for the first and second quarters of 2006, respectively.
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We ceased using leased space for our offices and warehouse in Fort Lauderdale, Florida during the second quarter of 2006. We recognized a liability of $72,752 during the quarter ended June 30, 2006, which represents the fair value of the lease costs that will continue to be incurred under the lease, net of sub-lease opportunities, for its remaining term through May 2008.
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Other costs incurred as a result of the restructuring include costs to consolidate or close our facilities in Fort Lauderdale and Los Angeles and to relocate certain activities to the Las Vegas distribution center, to Posh Tots’ headquarters in Richmond, and to our corporate office in Jupiter, Florida. The total amount of other restructuring costs was approximately $323,000, of which $74,000 and $249,000 were incurred and recognized as restructuring expenses in the first and second quarters of 2006, respectively.
Note 11 - Stock Option Plan
The Company’s 2001 Stock Award Plan was amended and restated in April 2005 by our board of directors and shareholders and renamed the “BabyUniverse 2005 Stock Incentive Plan” (Plan) under which officers, key employees, and non-employee directors may be granted options to purchase shares of the Company’s authorized but un-issued common stock. Under the Plan, the exercise price of each option equals the market price of the stock on the date of grant, the graded vesting period generally ranges between two and five years, and the contractual term ranges between two and ten years. See Accounting for Stock Based Compensation in Note 1 - Description of the Company and Summary of Significant Accounting Policies.
The fair value of each stock option granted is estimated on the date of the grant using the Black-Scholes option pricing model. The Company uses an estimated forfeiture rate of 0% due to limited experience with historical employee forfeitures. The Black-Scholes option pricing model also requires assumptions for risk free interest rates, dividend rate, stock volatility and expected life of an option grant. The risk free interest rates used ranged between 4.2% and 4.84% and were based on the U.S. Treasury Bill rate for maturities consistent with the expected life of the options which ranged between 1 to 3 years. Dividend rates are based on the Company’s dividend history. The stock volatility factor used of 56% was based on a peer group analysis of the stock market prices for eight comparable companies determined by the Company. Expected life is determined using the “simplified method” permitted by the SEC’s Staff Accounting Bulletin 107, since the Company does not have sufficient historical experience. The fair value of each option grant is recognized as compensation expense over the vesting period of the option on a straight line basis.
The following table summarizes information about stock option transactions for the years ended December 31, 2006, 2005 and 2004:
As of December 31, 2006, the aggregate intrinsic value of outstanding options was $729,062.
The following table summarizes information about stock options outstanding at December 31, 2006:
The Company recorded $130,007 of compensation expense for employee stock options during the year ended December 31, 2006. At December 31, 2006 there was a total of $295,955 of unrecognized compensation costs related to non-vested stock options issued under the plan and $234,643 of unrecognized compensation expense related to unvested restricted stock issued under the 2005 Plan.
During 2006, the Company granted an additional 25,000 of restricted shares under the 2005 Stock Incentive Plan, and 60,167 restricted shares vested. As such, at December 31, 2006 there are 102,054 unvested resticted shares.
As of December 31, 2006, an aggregate of 405,289 shares of common stock are reserved for issuance under the 2005 Stock Incentive Plan. Restricted stock grants and stock option grants were outstanding for an aggregate of 234,054 shares of stock, and 171,235 shares remained available for grant. In addition, there were outstanding options to purchase a total of 104,248 shares of our common stock, and 20,000 shares of restricted stock, which were granted outside of the 2005 Stock Incentive Plan. Shares issued pursuant to the Stock Incentive Plan will be newly-issued and authorized shares of common stock, or treasury shares.
Note 12 - Income Taxes
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities consist of the following:
Net deferred tax assets have been fully offset by a valuation allowance due to the uncertainty of realizing such benefit. At December 31, 2006, the Company had net operating loss carryforwards of approximately $6.9 million for federal and $6.8 million for state tax purposes which are set to expire in various years through 2026.
The reconciliation of income tax expense computed at the U.S. federal statutory rate to income tax expense for the years ended December 31, 2006, 2005 and 2004 are as follows:
Note 13 - Commitments and Contingencies
Commitments
Rent expense charged to operations under these operating leases was $667,972, $150,796 and $79,023 for the years ended December 31, 2006, 2005 and 2004, respectively.
Future lease obligations for the years ending December 31 are as follows:
Capital leases consist of office and warehouse equipment with capitalized amounts of $39,727 and $15,697 for the years ended December 31, 2006 and 2005, respectively.
Litigation
The Company is engaged in legal actions that arise from time to time in the normal course of business. The Company believes that the ultimate outcome of these actions will not have a material impact on its financial position, results of operations or cash flows.
Sales Tax
Currently, decisions of the U.S. Supreme Court restrict the imposition of obligations to collect state and local sales and use taxes with respect to sales made over the Internet. However, implementation of the restrictions imposed by these Supreme Court decisions is subject to interpretation by state and local taxing authorities. While we believe that these Supreme Court decisions currently restrict state and local taxing authorities outside the states of Florida, Nevada and Virginia from requiring us to collect sales and use taxes from purchasers located within their jurisdictions, taxing authorities outside the states of Florida, Nevada and Virginia could disagree with our interpretation of these decisions. Moreover, a number of states, as well as the U.S. Congress, have been considering various initiatives that could limit or supersede the Supreme Court’s position regarding sales
and use taxes on Internet sales. If any state or local taxing jurisdiction were to disagree with our interpretation of the Supreme Court’s current position regarding state and local taxation of Internet sales, or if any of these initiatives were to address the Supreme Court’s constitutional concerns and result in a reversal of its current position, we could be required to collect sales and use taxes from purchasers located in states other than Florida, Nevada and Virginia. An unfavorable resolution of some or all of these matters could materially affect our business, results of operations, financial position, or cash flows in a particular period.
Note 14 - Earnings (Loss) Per Share
Basic earnings (loss) per share is based on the weighted average number of common shares outstanding. Diluted earnings (loss) per share is based on the weighted average number of common shares and equivalents outstanding. Common share equivalents included in the computation represent shares issuable upon assumed exercise of outstanding stock options and warrants, and the non-vested portion of restricted stock.
The following table sets forth the computation of basic and diluted earnings (loss) per share:
The following is a summary of the securities outstanding during the respective periods that have been excluded from the calculations because the effect on earnings (loss) per share would have been antidilutive:
Note 15 - Segment Information
The Company operates in a single business segment as a leading online retailer and content provider of baby, toddler and maternity products and information through several online websites.
Note 16 - Quarterly Results
The following tables contain selected unaudited statement of operations information for each quarter of 2006, 2005, and 2004. The following information reflects all normal recurring adjustments necessary for a fair presentation of the information for the periods presented. The operating results for any quarter are not necessarily indicative of results for any future period. Unaudited quarterly results were as follows:
The sum of quarterly basic and diluted per share amounts may not equal per share amounts reported for year ended periods. This is due to changes in the number of weighted average shares outstanding and the effects of rounding for each period.
Note 17 - Transactions With Related Parties
Private Placement of Equity Securities
On September 22, 2006, BabyUniverse, Inc. closed on $2 million in new equity financing. The equity financing was provided by affiliates of Wyndcrest Holdings, LLC, a company controlled by BabyUniverse CEO John Textor. In connection with the financing, the Company received aggregate proceeds of approximately $2 million, based on the issuance of 263,852 shares of common stock priced at $7.58 per share, a 7.5% premium to the closing price on September 22, 2006. These funds will be used for general corporate purposes.
The shares of the common stock issued in the private placement were not registered under the Securities Act of 1933, pursuant to the exemption provided in Section 4(2), and may not be subsequently offered or sold by the investors in the United States absent registration or an applicable exemption from the registration requirements. BabyUniverse filed a Registration Statement on Form S-3 (No. 333-139712) on December 28, 2006 covering registration of the common stock acquired by the investors pursuant to the private plaement.
On December 29, 2006, BabyUniverse, Inc. entered into a Loan Agreement (the “Lydian Loan Agreement”) with Lydian Private Bank, pursuant to which Lydian Private Bank provided a term loan of $2,000,000 to the Company (the “Lydian Loan”), evidenced by a Promissory Note in that principal amount dated December 29, 2006 (the “Lydian Note”). The Lydian Loan bears interest at a floating rate of interest equal to the base rate on corporate loans posted by at least 75% of the nation’s largest banks, known as the “Wall Street Journal Prime,” which interest is payable monthly beginning on February 1, 2007. The maturity date of the Lydian Loan is July 1, 2008, at which time all outstanding principal and accrued but unpaid interest thereunder must be repaid to Lydian Private Bank.
As security for the Lydian Loan, Wyndcrest Baby Universe Holdings II, LLC, a Florida limited liability company, and Wyndcrest BabyUniverse Holdings III, LLC, a Florida limited liability company, each of which is controlled by John C. Textor, the Company’s Chairman and Chief Executive Officer, pledged to Lydian Private Bank shares of the Company’s Common Stock held by them, which shares also serve as collateral under a loan previously extended to such pledgors by Lydian Private Bank. In addition, each such pledgor and Mr. Textor have executed a guaranty of the Lydian Loan in favor of Lydian Private Bank. The Lydian Loan Agreement and the Lydian Note contain customary events of default for facilities of this type; upon the occurrence of any such event of default, Lydian Private Bank shall be entitled to all rights and remedies available to it against the Company under law and the Lydian Loan Agreement and the Lydian Note, including, without limitation, the right to accelerate and demand immediate repayment of all sums due thereunder.
Note 18 - Subsequent Events
Strategic Alternatives
On August 14, 2006, BabyUniverse announced that its Board of Directors decided to begin a process to explore strategic alternatives to enhance shareholder value including, but not limited to, the acquisition of a substantial private company, the acquisition of a complementary public company or a potential sale of the Company. On October 5, 2006, the Company announced that it had retained Banc of America Securities LLC as its financial advisor. There can be no assurance that a transaction will result from this process and the Company does not intend to disclose developments regarding its exploration unless and until the Company’s Board of Directors has approved a specific transaction.
On March 13, 2007, the Company entered into a definitive Agreement and Plan of Merger (the “Merger Agreement”) with eToys Direct, Inc. (“eToys Direct”), an e-commerce and direct marketer of toys and other youth-related products. Under the terms of the Merger Agreement, which has been approved by the Company’s Board of Directors, the Company will exchange shares of its Common Stock, par value $0.001 per share (the “Common Stock”), for all the outstanding shares of eToys Direct. Immediately following the merger contemplated by the Merger Agreement (the “Merger”), BabyUniverse shareholders at the time immediately prior to the Merger will own approximately one-third, and eToys Direct shareholders at the time immediately prior to the Merger will own approximately two-thirds, of the outstanding Common Stock.
The Company and eToys Direct have made customary representations, warranties and covenants to one another in the Merger Agreement. Consummation of the Merger is subject to certain conditions, including, among others, the approval of the Merger Agreement by the holders of the Common Stock, the repayment by the Company of all of its indebtedness for borrowed money outstanding as of the closing of the Merger, and the absence of any law or order prohibiting the consummation of the Merger. The Merger Agreement contains certain termination rights for both the Company and eToys Direct, and further provides that, upon termination of the Merger Agreement under specified circumstances, the Company may be required to pay eToys Direct a termination fee of $1,567,178, and reimburse eToys Direct for the expenses incurred by it in connection with the transaction in a maximum amount of $1,500,000.
Exhibit Index
21.1
Subsidiaries of Registrant
23.1
Consent of Singer Lewak Greenbaum & Goldstein LLP, Independent Registered Public Accounting Firm
23.2
Consent of Lieberman & Associates, P.A., Independent Registered Public Accounting Firm
31.1
Certification by John C. Textor, Chief Executive Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification by Michael Hull, Chief Financial Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification by John C. Textor, Chief Executive Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2
Certification by Michael Hull, Chief Financial Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
E-1