| SOURCE INTERLINK COMPANIES INC ITEM 1A RISK FACTORS 12 ITEM 1A RISK FACTORS Set forth below and elsewhere in this Annual Report on Form 10-K and in other documents we file with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward looking statements contained in this Annual Report on Form 10-K RISKS RELATING TO THE BUSINESS WE HAVE A CONCENTRATED CUSTOMER BASE AND OUR REVENUES COULD BE ADVERSELY AFFECTED IF WE LOSE ANY OF OUR LARGEST CUSTOMERS OR THESE CUSTOMERS ARE UNABLE TO PAY AMOUNTS DUE TO US A significant percentage of our sales are derived from a limited number of customers |
| accounted for approximately 27dtta5prca of our total revenues |
| We expect to continued to be dependent on a small number of customers for a substantial portion of our revenues |
| If any of these customers were to terminate their relationship with us, significantly reduce their purchases from us or experience problems in paying amounts due to us, it would result in a material reduction in our revenues and operating profits |
| WE DEPEND ON ACCESS TO CREDIT We will have significant working capital requirements principally to finance inventory and accounts receivables |
| We are currently a party to a revolving credit facility with a syndicate of lenders arranged by Wells Fargo Foothill, Inc |
| In addition, we are extended trade credit by our suppliers |
| Our business will depend on the availability of a credit facility and continued extension of credit by suppliers to support our working capital requirements |
| To maintain the right to borrow revolving loans and avoid a default under a credit facility, we will be required to comply with various financial and operating covenants and maintain sufficient eligible assets to support revolving loans pursuant to a specified borrowing base |
| Our ability to comply with these covenants or maintain sufficient eligible assets may be affected by events beyond our control, including prevailing economic, financial and industry conditions, and we may be unable to comply with these covenants or maintain sufficient eligible assets in the future |
| A breach of any of these covenants or the failure to maintain sufficient eligible assets could result in a default under these credit facilities |
| If we default, our lenders will no longer be obligated to extend revolving loans to us and could declare all amounts outstanding under our credit facility, together with accrued interest, to be immediately due and payable |
| If we were unable to repay those amounts, our lenders could proceed against the collateral interest granted to them to secure that indebtedness |
| The results of such actions would have a significant negative impact on our results of operations and financial condition |
| A DISRUPTION IN THE OPERATIONS OF OUR KEY SHIPPER OR SHARPLY HIGHER COSTS COULD CAUSE A DECLINE IN OUR SALES OR A REDUCTION IN OUR EARNINGS We are dependent on commercial freight carriers, primarily UPS, to deliver our products |
| If the operations of these carriers are disrupted for any reason, we may be unable to deliver our products to our customers on a timely basis |
| If we cannot deliver our products in an efficient and timely manner, our customers may reduce their orders from us and our revenues and operating profits could materially decline |
| For the year ended January 31, 2006, our freight cost represented approximately 4dtta8prca of our revenue |
| If freight costs were to increase and we were unable to pass that increase along to our customers due to competition within our industry, our financial results could materially suffer |
| Page 12 of 71 In a rising fuel cost environment, our freight costs may increase |
| If we are unable to pass the increased costs along to our customers, our results of operation may materially decline |
| OUR STRATEGY WILL INCLUDE MAKING ADDITIONAL ACQUISITIONS THAT MAY PRESENT RISKS TO THE BUSINESS Making additional strategic acquisitions is part of our strategy |
| The ability to make acquisitions will depend upon identifying attractive acquisition candidates and, if necessary, obtaining financing on satisfactory terms |
| Acquisitions, including those that we have already made, may pose certain risks to us |
| These include the following: - we may be entering markets in which we have limited experience; - the acquisitions may be potential distractions to management and may divert company resources and managerial time; - it may be difficult or costly to integrate an acquired business &apos financial, computer, payroll and other systems into our own; - we may have difficulty implementing additional controls and information systems appropriate for a growing company; - some of the acquired businesses may not achieve anticipated revenues, earnings or cash flow; - we may not achieve the expected benefits of the transactions including increased market opportunities, revenue synergies and cost savings from operating efficiencies; - difficulties in integrating the acquired businesses could disrupt client service and cause us to lose customers; - we may have unanticipated liabilities or contingencies from an acquired business; - we may have reduced earnings due to amortization expenses, goodwill impairment charges, increased interest costs and costs related to the acquisition and its integration; - we may finance future acquisitions by issuing common stock for some or all of the purchase price which could dilute the ownership interests of the stockholders; - acquired companies will have to become, within one year of their acquisition, compliant with SEC rules relating to internal control over financial reporting adopted pursuant to the Sarbanes-Oxley Act of 2002; - we may be unable to retain management and other key personnel of an acquired company; and - we may impair relationships with an acquired companyapstas employees, suppliers or customers by changing management |
| To the extent that the value of the assets acquired in any prior or future acquisitions, including goodwill or intangible assets with indefinite lives, becomes impaired, our company would be required to incur impairment charges that would affect earnings |
| Such impairment charges could reduce our earnings and have a material adverse effect on the market value of our common stock |
| For example, in connection with our fiscal 2002 acquisition of a magazine distribution company, we recorded an asset impairment charge totaling dlra78dtta1 million |
| If we are unsuccessful in meeting the challenges arising out of our acquisitions, our business, financial condition and future results could be materially harmed |
| Page 13 of 71 WE DEPEND ON ACCESS TO ACCURATE INFORMATION ON RETAIL SALES OF MAGAZINES IN ORDER TO OFFER CERTAIN SERVICES TO OUR CUSTOMERS, AND WE COULD LOSE A SIGNIFICANT COMPETITIVE ADVANTAGE IF OUR ACCESS TO SUCH INFORMATION WERE DIMINISHED We use information concerning the retail sales of single copy magazines to: - compare the revenue potential of various front-end fixture designs to assist our customers in selecting designs intended to maximize sales in the front-end; - identify sales trends at individual store locations permitting us to provide just-in-time inventory replenishment and prevent stock outs; and - offer both retailers and publishers information services, such as ICN and Cover Analyzer, and customized sales reporting |
| We gain access to this information principally through relationships with AC Nielsen & Company and Barnes & Noble, Inc |
| We do not currently have written agreements with these providers |
| We also obtain a significant amount of information in connection with our rebate claim submission services |
| Our access to information could be restricted as a result of the inability of any of our data partners to supply information to us or as a result of the discontinuation or substantial modification of the current incentive payment programs for magazines |
| If our access to information were reduced, the value of our information and design services could materially diminish and our publisher and retailer relationships could be negatively impacted |
| OUR REVENUE FROM THE SALES OF DVDS AND CDS MAY SUFFER DUE TO A SHIFT IN CONSUMER DEMAND AWAY FROM THE PHYSICAL MEDIA AND TOWARD DIGITAL DOWNLOADING AND OTHER DELIVERY METHODS Current technology allows consumers to buy music digitally from many providers such as Apple Computer (through iTunes), Music Match, Rhapsody, Microsoft (through MSN) and others |
| The sale of digital music has grown significantly in the past year, and the recording industry saw sales revenue for CDs decline significantly from 2001 to 2005 |
| As this method of selling music increases in popularity and gains consumer acceptance, it may adversely impact our sales and profitability |
| The recording industry also continues to face difficulties as a result of illegal online file-sharing and downloading |
| While industry associations and manufacturers have successfully launched legal action against downloaders and file sharers to stop this practice, there can be no assurance of the effect of these lawsuits |
| File sharing and downloading, both legitimate and illegal, could continue to exert pressure on the recording industry and the demand for CDs |
| Additionally, as other forms of media become available for digital download, our sales and profitability attributable to CDs and DVDs may be adversely affected |
| Recent advances in the technologies to deliver movies to viewers may adversely affect public demand for DVDs offered by us |
| For example, some digital cable providers and internet companies offer movies "e on demand "e with interactive capabilities such as start, stop and rewind |
| Direct broadcast satellite and digital cable providers have been able to enhance their on-demand offerings as a result of their ability to transmit over numerous channels |
| Although not as advanced as the digital distribution of music, Apple Computer (through iTunes) and others have begun to offer video content digitally |
| Apart from on-demand technology, the recent development and enhancement of personal video recorder technology with "e time-shifting "e technology (such as that used by TiVo and certain cable companies) has given viewers greater interactive control over broadcasted movies and other program types |
| Also, companies such as Blockbuster Entertainment and NetFlix are now offering subscription services which provide consumers the ability to rent VHS cassettes and DVDs for indefinite periods of time without being subject to late fees |
| If these methods of watching filmed entertainment increase in popularity and gain consumer acceptance, they may adversely impact sales and profits |
| WE PARTICIPATE IN HIGHLY COMPETITIVE INDUSTRIES AND COMPETITIVE PRESSURES MAY RESULT IN A DECREASE IN OUR REVENUES AND PROFITABILITY Each of our business units faces significant competition |
| Our Fulfillment group distributes home entertainment Page 14 of 71 product in competition with a number of national and regional companies, including Anderson News Company, Anderson Merchandisers, LP, Hudson News Company, News Group, Ingram Book Group, Inc, Ingram Entertainment, Inc, Handleman Company, and Baker & Taylor, Inc |
| Major record labels and film studios periodically compete with us by establishing direct trading relationships with the larger retail chains |
| Our In-Store Services group competes in a highly fragmented industry with other manufacturers for wood and wire display fixture business |
| In addition, some of this groupapstas information and management services may be performed directly by publishers and other vendors, retailers or distributors |
| Other information service providers, including AC Nielsen Company, Information Resources and Audit Bureau of Circulations, also collect sales data from retail stores |
| If these service providers were to compete with us, given their expertise in collecting information and their industry reputations, they could be formidable competitors |
| Some of our existing and potential competitors have substantially greater resources and greater name recognition than we do with respect to the market or market segments they serve |
| Because of each of these competitive factors, we may not be able to compete successfully in these markets with existing or new competitors |
| Competitive pressures may result in a decrease in the number of customers it serves, a decrease in its revenues or a decrease in its operating profits |
| WE CONDUCT A GROWING PORTION OF OUR BUSINESS INTERNATIONALLY, WHICH PRESENTS ADDITIONAL RISKS TO US OVER AND ABOVE THOSE ASSOCIATED WITH OUR DOMESTIC OPERATIONS Approximately 2dtta1prca of our total revenues for the year ended January 31, 2006 were derived from the export of US publications to overseas markets, primarily to the United Kingdom and Australia |
| In addition, approximately 6dtta9prca of our gross domestic distribution for the year ended January 31, 2006, consisted of the domestic distribution of foreign publications imported for sale to US markets |
| The conduct of business internationally presents additional inherent risks including: - unexpected changes in regulatory requirements; - import and export restrictions; - tariffs and other trade barriers; - differing technology standards; - resistance from retailers to our business practices; - employment laws and practices in foreign countries; - political instability; - fluctuations in currency exchange rates; - imposition of currency exchange controls; and - potentially adverse tax consequences |
| Any of these risks could adversely affect revenue and operating profits of our international operations |
| Certain suppliers have adopted policies restricting the export of DVDs and CDs by domestic distributors |
| However, consistent with industry practice, we distribute our merchandise internationally |
| We would be adversely affected if a substantial portion of our suppliers enforced any restriction on our ability to sell our home entertainment content products outside the United States |
| Page 15 of 71 SUBSTANTIALLY ALL OF THE MAGAZINES DISTRIBUTED BY US ARE PURCHASED FROM FOUR SUPPLIERS AND OUR REVENUES COULD BE ADVERSELY AFFECTED IF WE ARE UNABLE TO RECEIVE MAGAZINE ALLOTMENTS FROM THESE SUPPLIERS Substantially all of the magazines distributed in the United States are supplied by or through one of four national distributors, Comag Marketing Group, LLC, Curtis Circulation Company, Kable Distribution Services, Inc |
| Each title is supplied by one of these national distributors to us and cannot be purchased from any alternative source |
| Our success is largely dependent on our ability to obtain product in sufficient quantities on competitive terms and conditions from each of the national distributors |
| In order to qualify to receive copy allotments, we are required to comply with certain operating conditions, which differ between the specialty retail market and the mainstream market |
| Our ability to economically satisfy these conditions may be affected by events beyond our control, including the cooperation and assistance of our customers |
| A failure to satisfy these conditions could result in a breach of our purchase arrangements with our suppliers and entitle our suppliers to reduce our copy allotment or discontinue our right to receive product for distribution to our customers |
| If our supply of magazines were reduced, interrupted or discontinued, customer service would be disrupted and existing customers may reduce or cease doing business with us altogether, thereby causing our revenue and operating income to decline and result in failure to meet expectations |
| IF WE WERE UNABLE TO RECEIVE OUR CD AND DVD PRODUCTS FROM OUR TOP SUPPLIERS, OUR SALES AND PROFITABILITY COULD BE ADVERSELY AFFECTED A substantial portion of the DVD and CD products distributed by us are supplied by 5 film studios and 4 record labels |
| These products are proprietary to individual suppliers and may not be obtained from any alternative source |
| Our success depends upon our ability to obtain product in sufficient quantities on competitive terms and conditions from each of these major home entertainment labels and studios |
| If our supply of products were interrupted or discontinued, then customer service could be adversely affected and customers may reduce or cease doing business with us causing our sales and profitability to decline |
| VIRTUALLY ALL OF OUR SALES ARE MADE ON A "e SALE OR RETURN "e BASIS AND HIGHER THAN EXPECTED RETURNS COULD CAUSE US TO OVERSTATE REVENUE FOR THE PERIOD AFFECTED As is customary in the home entertainment content product industry, virtually all of our sales will be made on a "e sale or return "e basis |
| During the year ended January 31, 2006, approximately 60 out of every 100 magazine copies distributed domestically by Source Interlink and approximately 19 out of every 100 DVDs and CDs distributed domestically by Alliance were returned unsold by their customers for credit; however, the sell-through rate can vary from period to period |
| Revenues from the sale of merchandise that we distribute are recognized at the time of delivery, less a reserve for estimated returns |
| If sell-through rates in any period are significantly less than historical averages, this return reserve could be inadequate |
| This would require an increase in the amount of the return reserve for subsequent periods which may result in a reduction in operating income for such periods |
| SALES OF DVDS AND CDS ARE HIGHLY SEASONAL AND OUR FINANCIAL RESULTS COULD BE NEGATIVELY IMPACTED IF THE FOURTH QUARTER SALES OF DVDS AND CDS ARE WEAK Our CD and DVD Fulfillment segment generated 31dtta7prca of its total net sales in the fourth quarter of fiscal 2006 coinciding with the holiday shopping season |
| Factors that could adversely affect sales and profitability in the fourth quarter include: - unavailability of, and low customer demand for, particular products; - unfavorable economic and geopolitical conditions; Page 16 of 71 - inability to hire adequate temporary personnel; - weather conditions; - inability to anticipate consumer trends; and - inability to maintain adequate inventory levels |
| WE DEPEND ON THE EFFORTS OF CERTAIN KEY PERSONNEL, THE LOSS OF WHOSE SERVICES COULD ADVERSELY AFFECT OUR BUSINESS We depend upon the services of our chief executive officer and chief operating officer and their relationships with customers and other third parties |
| The loss of these services or relationships could adversely affect our business and the implementation of our growth strategy |
| This in turn could materially harm our financial condition and future results |
| Although we have employment agreements with each of our chief executive officer and chief operating officer, the services of these individuals may not continue to be available to the combined company |
| We carry key person life insurance on the lives of both our chief executive officer and chief operating officer |
| OUR MANAGEMENT AND INTERNAL SYSTEMS MIGHT BE INADEQUATE TO HANDLE OUR POTENTIAL GROWTH To manage future growth, our management must continue to improve operational and financial systems and expand, train, retain and manage its employee base |
| We will likely be required to manage an increasing number of relationships with various customers and other parties |
| If our systems, procedures and controls are inadequate to support our operations, our expansion could be halted and we could lose opportunities to gain significant market share |
| Any inability to manage growth effectively may harm our business |
| OUR OPERATIONS COULD BE DISRUPTED IF OUR INFORMATION SYSTEMS FAIL, CAUSING INCREASED EXPENSES AND LOSS OF SALES Our business depends on the efficient and uninterrupted operation of our computer and communications software and hardware systems, including our replenishment and order regulation systems, and other information technology |
| If we were to fail for any reason or if we were to experience any unscheduled down times, even for only a short period, its operations and financial results could be adversely affected |
| We have in the past experienced performance problems and unscheduled down times, and these problems could recur |
| Our systems could be damaged or interrupted by fire, flood, hurricanes, power loss, telecommunications failure, break-ins or similar events |
| We have formal disaster recovery plans in place |
| However, these plans may not be entirely successful in preventing delays or other complications that could arise from information systems failure, and, if they are not successful, our business interruption insurance may not adequately compensate it for losses that may occur |
| WE DEPEND ON THE INTERNET TO DELIVER SOME OF OUR SERVICES, AND THE USE OF THE INTERNET MAY EXPOSE US TO INCREASED RISKS Many of our operations and services, including replenishment and order regulation systems, PIN, ICN, customer direct fulfillment and other information technology, involve the transmission of information over the Internet |
| Our business therefore will be subject to any factors that adversely affect Internet usage including the reliability of Internet service providers, which from time to time have operational problems and experience service outages |
| In addition, one of the requirements of the continued growth over the Internet is the secure transmission of confidential information over public networks |
| Failure to prevent security breaches of our networks or those of our customers or well-publicized security breaches affecting the Internet in general could significantly harm our growth and revenue |
| Advances in computer capabilities, new discoveries in the field of cryptography or other developments may result in a compromise or breach of the algorithms we use to protect content and transactions or our customers &apos Page 17 of 71 proprietary information in its databases |
| Anyone who is able to circumvent our security measures could misappropriate proprietary and confidential information or could cause interruptions in our operations |
| We may be required to expend significant capital and other resources to protect against such security breaches or to address problems caused by security breaches |
| IF OUR ACCOUNTING CONTROLS AND PROCEDURES ARE CIRCUMVENTED OR OTHERWISE FAIL TO ACHIEVE THEIR INTENDED PURPOSES, OUR BUSINESS COULD BE SERIOUSLY HARMED Although we evaluate our internal control over financial reporting and disclosure controls and procedures as of the end of each fiscal quarter, we may not be able to prevent all instances of accounting errors or fraud in the future |
| Controls and procedures do not provide absolute assurance that all deficiencies in design or operation of these control systems, or all instances of errors or fraud, will be prevented or detected |
| These control systems are designed to provide reasonable assurance of achieving the goals of these systems in light of legal requirements, company resources and the nature of our business operations |
| These control systems remain subject to risks of human error and the risk that controls can be circumvented for wrongful purposes by one or more individuals in management or non-management positions |
| Our business could be seriously harmed by any material failure of these control systems |
| THE DVD AND CD BUSINESS DEPENDS IN PART ON THE CURRENT ADVERTISING ALLOWANCES, VOLUME DISCOUNTS AND OTHER SALES INCENTIVE PROGRAMS, AND OUR RESULTS OF OPERATION COULD BE ADVERSELY AFFECTED IF THESE PROGRAMS WERE DISCONTINUED OR MATERIALLY MODIFIED Under terms of purchase prevailing in its industry, the profitability of the DVD and CD are enhanced by advertising allowances, volume discounts and other sales incentive programs offered by record labels and movie studios |
| Such content providers are not under long-term contractual obligations to continue these programs, and in 2003 one major record label eliminated advertising allowances and volume discounts on a limited number of stock keeping units |
| If record labels or movie studios, or both, decide to discontinue these programs, we would experience a significant reduction in operating profits |
| RISKS RELATED TO YOUR OWNERSHIP OF OUR STOCK WE HAVE A SIGNIFICANT STOCKHOLDER WHOSE INTERESTS MAY CONFLICT WITH YOURS Our largest stockholder, AEC Associates, LLC beneficially owned approximately 34prca of our outstanding voting power as of April 10, 2006 |
| For as long as AEC Associates (together with its members and affiliates acting as a group) owns an aggregate of at least 10prca of our outstanding common stock, AEC Associates will have certain additional director designation rights as further described in the risk factor entitled "e We have limitations on changes of control that could reduce your ability to sell our shares at a premium "e |
| For example, for actions that require a supermajority of the board, such as a change of control, AEC Associates designated directors may effectively have enough votes to prevent any such action from being taken by us |
| As a result, AEC Associates will have the ability through its ownership of our common stock and its representation on the board to exercise significant influence over our major decisions and over all matters requiring stockholder approval |
| AEC Associates may have interests that differ from those of our stockholders |
| OUR BYLAWS WILL REQUIRE SUPERMAJORITY APPROVAL OF OUR BOARD BEFORE WE CAN TAKE CERTAIN ACTIONS THIS REQUIREMENT MAY RESTRICT STRATEGIC TRANSACTIONS INVOLVING US Our bylaws provide that the affirmative vote of at least 75prca of its entire board will be required to (i) approve or recommend a reorganization or merger of our company in a transaction that will result in our stockholders immediately prior to such transaction not holding, as a result of such transaction, at least 50prca of the voting power of the surviving or continuing entity, (ii) a sale of all or substantially all of our assets which would result in its stockholders immediately prior to such transaction not holding, as a result of such sale, at least 50prca of the voting power of the purchasing entity, or (iii) a change in our bylaws |
| This requirement may prevent us from making Page 18 of 71 changes and taking other actions that are subject to this supermajority approval requirement |
| This requirement may limit our ability to pursue strategies or enter into strategic transactions for which the supermajority approval of the board cannot be obtained |
| WE HAVE LIMITATIONS ON CHANGES OF CONTROL THAT COULD REDUCE YOUR ABILITY TO SELL OUR SHARES AT A PREMIUM Our certificate of incorporation and bylaws currently contain provisions that could reduce the likelihood of a change of control or acquisition of our company, which could limit your ability to sell our shares at a premium or otherwise affect the price of our common stock |
| These provisions include the following: - permit our board to issue up to 2cmam000cmam000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions of that preferred stock; - permit our board to issue up to 100cmam000cmam000 shares of common stock; - require that a change of control of the company be approved by a supermajority of at least 75prca of the members of the board; - provide for a classified board of directors; - provide that, for as long as AEC Associates (together with its members and affiliates acting as a group) owns an aggregate of at least 10prca of the combined companyapstas common stock, AEC Associates will have the right to designate an individual (or individuals) of its choice for election by the board for any seat that is last occupied or vacated by a director designated by Alliance or AEC Associates, except if such designation would result in the directors designated by AEC Associates having a disproportionate board representation to AEC Associates &apos (together with its members and affiliates acting as a group) ownership of our common stock; - permit the board to increase its own size and fill the resulting vacancies; - limit the persons who may call special meetings of stockholders; and - establish advance notice requirements for nominations for election to the board or for proposing matters that can be acted on by stockholders at stockholders meetings |
| OUR COMMON STOCK PRICE HAS BEEN VOLATILE, WHICH COULD RESULT IN SUBSTANTIAL LOSSES FOR STOCKHOLDERS Our common stock is currently traded on the Nasdaq National Market |
| Our average daily trading volume for the three month period ending April 10, 2006 was approximately 465cmam000 shares |
| The trading price of our common stock has been and may continue to be volatile |
| The closing sale prices of our common stock, as reported by the Nasdaq National Market, have ranged from a high of dlra13dtta19 to a low of dlra9dtta38 for the 52-week period ending January 31, 2006 |
| Broad market and industry fluctuations may significantly affect the trading price of our common stock, regardless of our actual operating performance |
| The trading price of our common stock could be affected by a number of factors, including, but not limited to, announcements of new services, additions or departures of key personnel, quarterly fluctuations in our financial results, changes in analysts &apos estimates of our financial performance, general conditions in our industry and conditions in the financial markets and a variety of other risk factors, including the ones described elsewhere in this Annual Report on Form 10-K Periods of volatility in the market price of a companyapstas securities sometimes result in securities class action litigation |
| If this were to happen to us, such litigation would be expensive and would divert managementapstas attention |
| In addition, if we needed to raise equity funds under adverse conditions, it would be difficult to sell a significant amount of our stock without causing a significant decline in the trading price of our stock |