ITEM 1: BUSINESS
GENERAL
We are a premier outsourcing solutions provider for the education community. Under the umbrella of our “VarsityBooks” and “Campus Outfitters” brands we offer a comprehensive outsource solution to provide textbooks, uniforms and school supplies to private K-12 schools, colleges, and distance and continuing education markets. Our textbook and apparel solutions are designed to release our partner institutions from the operational and financial challenges associated with managing highly seasonal retail operations and allows them to focus valuable resources on their core educational mission. Our textbook program, eduPartners, was the first online bookstore solution focused on meeting the needs of private middle and high schools nationwide. Please see Note 16 to our consolidated financial statements for financial information on our two business segments, textbook trade and uniform trade.
Students and families enjoy the convenience of purchasing learning materials, school uniforms, and other supplies through our convenient online stores (located at www.varsitybooks.com and www.campusoutfitters.com), at select retail locations or at managed on-campus sales events. To date, the primary channel for textbook sales has been through online eCommerce transactions, while the majority of our uniform sales have been recognized through retail stores and on-campus sales events.
Within our textbook solution, we create a customized virtual bookstore for each partner school which is hosted on our website, www.varsitybooks.com. This site contains the required and optional educational materials and supplies selected by the school organized by grade, academic discipline and course name. Students and parents from each of our partner schools access their customized bookstore to place their orders via a direct link from their school’s homepage or by searching for their school bookstore by region and state on our homepage. Once an order has been submitted, it is typically picked, packed and shipped within one business day from one of three distribution centers nationwide.
Member schools leverage our textbook solution to lower their operating overhead by outsourcing their bookstore operation while delivering a more efficient and flexible bookstore solution to their community. In addition, our partner schools have access to our unique program administration website that provides them with sales and inventory reports, among other valuable features. Student and parent customers value the convenience of our online shopping experience and take comfort in the knowledge that our posted booklists have been reviewed for content and accuracy and approved by their school. As a further convenience to parents, students and school officials, to the extent any of our partner schools adopt textbooks to be used in the next school term, we will typically offer parents and students several options to sell back their textbooks to us at the end of the school year, helping to lower their total cost of textbook ownership. These used textbooks are offered for sale the following school year providing our student and parent customers lower cost pricing alternatives.
As part of our strategy to expand the number of services and products we offer our customers, we acquired Campus Outfitters in May 2005, creating a single source solution for school textbook and uniform needs. Our acquisition of Campus Outfitters allows us to leverage relationships with schools partnered under either our textbook or uniform programs by cross-promoting the other product lines. Through the Campus Outfitters brand, we own and operate nine retail locations serving private K-12 school communities as their official school uniform provider. As a further convenience to our uniform customers, we travel to eligible schools and conduct on-campus sales events during which families can purchase and take home all necessary uniform components the same day. Finally, parents and students always have the ability to shop online through customized virtual stores which are created on www.campusoutfitters.com for each partner school containing all required uniform components.
Similar to our textbook solution, partner uniform schools leverage their relationship with us to lower their operating overhead by outsourcing their school uniform operation while delivering a more flexible uniform solution to their community.
Throughout 2005, we continued to expand our core online textbook model, while integrating the Campus Outfitters acquisition which has added an exciting new revenue stream that targets the same private primary and secondary education markets our existing textbook program has established through a nationwide network of school relationships. During the year ended
December 31, 2005, revenues increased by 33% or $12.4 million to $50.1 million, from $37.7 million in fiscal 2004. Approximately $5.8 million of this increase in revenue was generated from our new uniform product line.
We believe a key aspect of our textbook and uniform models are the underlying school, parent and student relationships we build with each new partner school. The addition of Campus Outfitters in 2005 added approximately 300 additional school relationships to our network, focused primarily in the K-12 private education marketplace, increasing our total number of school relationships to almost 700. During fiscal 2005, we met the textbook or uniform needs of over 240,000 parent and student customers. Approximately 90% of our textbook accounts are currently private elementary and secondary schools and virtually all of our uniform accounts are currently private elementary and secondary schools.
During our second quarter of fiscal 2005, we again focused on increasing our used textbook inventory by expanding our on-campus textbook buyback program. Through these buyback events, we provide our partner school parents and students the option of selling back to us at the end of the current school year textbooks that our partner schools are adopting for use during the approaching school year. This increases the overall number of used textbooks available to our partner schools throughout the school year, lowers the total cost of textbook ownership for parents and students and provides customers more purchasing options. During fiscal 2005, approximately 14% of our textbook sales were from used books.
Our overall success and ability to maintain and increase profitability from operations will depend, in part, upon our ability to retain our current customers, successfully integrate acquisitions, attract additional schools to our programs, provide a compelling and satisfying shopping experience to our retail customers, and manage our relationship with our primary fulfillment partner, Baker and Taylor, Inc. (“B&T”), a leading distributor of books, videos and music products.
Substantially all of our computer and communications hardware and software systems are located at a single facility that is owned, maintained and serviced by a third party. Any damage, failure or delay that causes interruptions in our systems operations could materially harm our business.
Varsity Group Inc. was founded in 1997. We are a Delaware corporation with our principal executive offices located at 1850 M Street, NW, Suite 1150, Washington, D.C. 20036, and our telephone number is (202) 667-3400.
We provide website access to our periodic and current SEC filings and press releases, free of charge, on our website located at http://www.varsitygroup.com as soon as reasonably practicable after the materials are filed with the SEC or otherwise made public.
MARKET OVERVIEW
Textbook Market
The retail textbook market is presently dominated by on-campus bookstores at all educational levels, with most educational institutions either operating their own physical bookstore or contracting these services to a third party. However, both selling and purchasing new textbooks through traditional retail outlets can be expensive and inconvenient. Each year students and parents often face the prospects of long lines, inconvenient bookstore hours of operation and out-of-stock inventory problems causing delays and necessitating multiple trips to the bookstore.
Educational institutions also face many challenges associated with operating an efficient and profitable retail bookstore on campus. These challenges are exacerbated at smaller schools where operating economies of scale are not present and profitability and high customer service levels are more difficult to achieve or sustain. This is particularly true at the private middle and high school market, where there is typically only one major textbook buying season (Fall back-to-school) and supplemental clothing, school supplies and electronic product sales are limited or non-existent as a means to increase store profitability and smooth operational peaks.
Online commerce provides the opportunity to offer the college and private middle and high school student markets a more convenient and efficient alternative to the traditional brick-and-mortar bookstore model. We believe that, for a variety of reasons, few businesses have succeeded in offering students a comprehensive solution tailored to meet their varied needs in a convenient, reliable and cost-effective manner.
Private Elementary and Secondary Education
The private school market represents approximately 24% of all elementary and secondary schools and 10% of all elementary and secondary students, according to the National Center of Education Statistics (NCES). There are approximately 6.2 million students enrolled in over 29,000 private elementary and secondary schools nationwide. Approximately 4.9 million students are in elementary level schools and approximately 1.4 million students are in secondary level schools. Almost half of all private school
students attend schools that are located in urban areas. According to the Council on American Private Education, private secondary school enrollment is expected to increase as much as 7% between 2001 and 2013.
Based upon market research conducted by us, we believe there are at least 3,000 private middle and high schools nationwide that present an immediate fit with the strengths and benefits of our eduPartners model. Factors we considered in our research include school policy requiring students to purchase their own textbooks, school enrollment and the extent of state subsidy of textbooks for private school students. We believe approximately 600 schools in this segment had adopted an online textbook solution similar to our eduPartners model by the start of the 2005 back-to-school selling season. Of the estimated 600 schools served by an online textbook solution during the 2005 back-to-school selling season, approximately 350, or 52%, of those were served by our eduPartners program.
Higher Education
The college student market is large and growing. The National Association of College Stores reports that there are approximately 16.5 million undergraduate and graduate students at more than 4,150 colleges and universities in the United States. According to the NCES, college enrollment will increase to approximately 17.0 million students by 2008.
While the primary source of school growth within eduPartners has been the private middle and high school market to date, many higher education institutions share the same operational and financial challenges which make eduPartners such a compelling outsource solution to the elementary and secondary education market. In particular, smaller institutions struggle to deliver the budget, available retail space and operating economies of scale necessary to support a profitable bookstore operation. Forty one percent of higher education institutions have enrollments below 1,000 students, and just 10% have enrollments higher than 10,000 students, according to the National Association of College Stores.
Although the college market is large and diverse, students still have common needs. For instance, students typically must buy expensive school-related goods and services such as textbooks and school supplies. In fact, textbooks are most students’ single largest school related expenditure after tuition, room and board. The College Board reports that the average per student expense for books and supplies during 2003-2004 was $745 and $843 for two-year and four-year institutions, respectively. Overall textbook and course material sales were approximately $10.8 billion in the academic year 2003-2004, based on statistics published by the National Association of College Stores.
School Uniform Market
According to the NPD Group, Inc. the broader domestic retail school uniform market represents an annual $1.0 billion opportunity. However, this includes the very large “dress code” segment often associated with public school dress policies which, for example, may simply require students to wear a generic white dress shirt and khaki pants which can be purchased at most apparel retailers.
Our uniform solution is currently focused on an attractive sub-segment of the school uniform market serving private K-12 schools that have mandatory, branded school requirements served through exclusive retailer relationships. These products are a required purchase of every student and typically feature a school logo or other branding element on one or multiple uniform components. Management estimates that its initial target market size is approximately $200.0 million to $300.0 million in annual sales.
STRATEGY
Build a Significant and Profitable School Outsourcing Business.
During the last five years we believe that we have taken the steps necessary to create a profitable and scalable online book business with significant growth potential. In recent years, we have aggressively grown our revenues and our network of partner schools while maintaining strong margins and containing marketing, sales and overhead expenses. We believe, over time, expansion of our used book offering may allow for the expansion of product margins while delivering to our customers a more compelling, cost effective textbook solution. At the same time, the addition of our school uniform business with higher average margins than that of the book business may allow us to more rapidly grow both revenue and overall margins.
Our strategy is to continue to invest in the development of school relationships and expand our reach into private middle and high schools, traditional two and four year colleges, distance learning and other continuing education programs. We believe the textbook model affords our company certain scale benefits that will allow us to grow revenues aggressively while preserving margins over the next few years. With the addition of our uniform solution, we will begin to cross-promote our school uniform solution to our textbook customers and our textbook solution to our uniform customers. We will strive to expand the addressable market of target schools by continuously improving and refining our core textbook and uniform solutions, as well as exploring new products and services, book and non-book related, to meet the demand of our customers.
Increase Our Leadership Position of Our Textbook Solution Serving Private Middle and High Schools.
We will look to extend our current leadership position in the private middle and high school marketplace and extend our sales effort significantly beyond our initial target market of 3,000 schools and much deeper into the full universe of over 29,000 private elementary and secondary schools nationwide.
Our textbook program was the first online bookstore solution focused on meeting the needs of private middle and high schools. We have partner schools located in most key markets nationwide and are aggressively targeting remaining areas to establish a comprehensive nationwide network of member schools. We have successfully extended our presence in new markets by leveraging the positive experience and word-of-mouth generated once our initial account in that market has completed a successful back-to-school selling season.
Expand the Presence of our Textbook Solution in Higher Education and Continuing Education Markets.
Concurrent to our anticipated growth in the private elementary and secondary school market, we will commit the appropriate resources to attempt to accelerate our growth in the higher education and distance learning markets. We believe the textbook model offers a compelling value proposition to these target markets and are focused on aggressively building our network of schools in this segment.
Expand Apparel Solution To More Markets Nationwide and Expand Product Offering.
We plan to aggressively expand our network of uniform school relationships by increasing the number of schools in markets currently served by our nine retail locations and entering new markets nationwide by leveraging the Varsity brand and school relationships developed through our textbook solutions in those markets. We will also evaluate opportunities to acquire school uniform retailers in markets where we believe that opportunity may represent the most profitable and accretive path to the continue growth of our uniform business. We will also continue to explore opportunities to expand the scope of products and services we provide through our apparel business, including non-uniform branded or promotional school apparel, team or affinity group apparel and corporate branded apparel.
Identify New Product or Service Offerings To Enhance Current Solutions or Broaden School Relationships.
We will continue to explore opportunities to expand the scope of products and services we provide our partner schools and will aggressively pursue opportunities which we believe will enable us to introduce new, profitable revenue streams or strengthen the underlying school and end customer related assets we have forged through our textbook and uniform solutions.
THE VARSITY TEXTBOOK SOLUTION
We provide students, parents and schools with a reliable and convenient alternative to the traditional campus bookstore model. We are able to reduce the overhead associated with textbook sales because we typically do not maintain individual stores and are able to consolidate our ordering, inventory, warehousing and fulfillment needs through our relationship with B&T. In addition to providing textbooks at competitive prices, we are committed to providing best-in-class customer service, dedicated account management, customized websites for each partner school and rapid shipment of orders.
Through our textbook program, we provide an opportunity for educational institutions to maximize their resources and offer increased convenience to their students by outsourcing textbook sales to us. We believe that for many schools the expense and inconvenience of maintaining a physical retail bookstore on campus exceeds the school’s financial return. We provide an innovative solution for schools and enable them to offer increased convenience and value to students, their parents, and the entire school community. Our program has been uniquely designed to meet the needs of these schools by offering a number of compelling program features, including:
•
Dedicated Account Managers to serve schools;
•
Customized online bookstores featuring detailed course and book information;
•
Communications and training materials for each school community;
•
Innovative website program management tools providing school administrators access to sales and inventory reports;
•
Convenience and simplicity of a user-friendly online shopping experience;
•
Flexibility to purchase books for the upcoming semester/year from anywhere, anytime; and
•
Toll-free ordering options and superior customer service.
Through these relationships, we are endorsed as the exclusive textbook retailer at our eduPartners schools and gain direct access to their students. As a result, our textbook program is an attractive and economical way for us to acquire customers.
Our exclusive relationships generally are for a period of one to four years and typically automatically renew on a year-to-year basis. As of April 2006, substantially all program agreements associated with schools served during our 2005 back-to-school season have either been renewed or terminated. These agreements typically automatically renew for one year if neither party serves notice of intent to terminate 90 days prior to the date of expiration. We expect our revenue retention rate for fiscal 2006 to approximate 90% of total fiscal 2005 revenues. This figure is consistent with historical revenue retention rates which have approximated 90% or more year over year.
With our textbook program, we create a personalized virtual bookstore for each school on our website. Students are able to search by region and state on our homepage to locate the link to their co-branded bookstore. Parents and students can be linked directly to their school bookstore page from their school’s homepage. Once they reach the entry page to their customized online bookstore, the student or parent can navigate the site by clicking on the appropriate grade, discipline and class to select required and optional books. The school benefits by eliminating the operational and financial burdens associated with the physical operation of a highly seasonal retail bookstore on campus. In addition, schools have access to our unique program administration website that provides them with sales and inventory reports, among other valuable features.
User Experience
Our eCommerce website, www.varsitybooks.com, offers several benefits to customers including convenience, ease of use and depth of product selection. When logging on to our website, visitors are presented with several shopping options, including:
•
Searching by School. Students at our partner schools can use our customized map to locate their school. Once they find their school they can link through a list of subjects to a list of classes and to the specific booklists for the courses they are taking. Our customers have the option of placing all the textbooks for a particular class in their shopping cart with a single click or selecting only those titles that interest them.
•
Searching for Books. If we have not posted a specific school’s booklist, our customers can search for the books they need by author, title, keyword, publisher or ISBN. Our website offers additional book verification for many selections, including pictures of jacket art, editor’s name, volume number and other identifying characteristics.
Ordering and Delivery
When our customers are ready to place an order, they can proceed through our shopping cart function directly to our checkout page. Orders can be placed online through our website or via our toll-free telephone number where customer service agents are available to take orders from customers that do not have access to the Internet or are uncomfortable placing an order online. We presently accept major credit cards, money orders and personal checks as payment for our products. For our partner schools, we also offer school and student credit accounts.
Once a customer places an order, he or she immediately receives an e-mail that includes a unique order number and confirms that the order has been received and processed. If a book is not in stock at the time an order is processed, that title is automatically placed on backorder and shipped to the customer as soon as it returns to stock. Customers are not charged for any book until it has been shipped. After an order is shipped, the customer receives a second e-mail that includes a parcel tracking number, a description of titles shipped and placed on backorder, the amount charged to their credit card for this shipment and a link to a page on our website where they can follow their order through the delivery process. We use a variety of shipping services to offer our customers a selection of delivery options to ensure their orders are received in timely manner.
Customer Service
We are committed to delivering superior customer service to all of our customers, including our partner schools, parents and students. We offer extended customer service hours and increase our staffing levels during the busy back-to-school season, providing our customers convenient toll-free access to our customer service representatives and fast response to their queries. The customer service page of our website offers answers to frequently asked questions and enables our customers to ask their own questions through e-mail. We also have a toll-free customer service telephone number.
Fulfillment
B&T, a leading distributor of books, videos and music products, has provided our order fulfillment and drop shipment services since our inception. We have a series of agreements relating to the operating and financial terms of our relationship, which were recently renewed and are now scheduled to expire in June 2008.
Under these agreements, we agree to provide B&T with our written demand forecasts for each upcoming year and we agree to use B&T as our principal supplier of textbooks and exclusive provider of drop-ship and fulfillment services. We pay fees and
expenses related to the services B&T provides and we purchase products from B&T at a discount to the suggested price. In return, B&T agrees not to provide drop-ship services to any person or entity that has as its principal business activity the goal of establishing exclusive relationships with educational institutions for the purpose of selling textbooks via the Internet, unless the retailer was an existing customer of B&T on or prior to June 10, 1998, the date we initially contracted with B&T. Our agreements with B&T provide us access to, and use of, an electronic set of data elements from B&T’s title file database that contains bibliographic records. In addition, under these agreements, B&T provides us with promotional, customer service, and database management services.
As a result of the data access our agreements provide, information on availability of book titles is automatically updated on our website on an hourly basis based on title and inventory data feeds from B&T, ensuring that our customers receive accurate in-stock inventory information. Orders placed on our website are automatically transmitted to B&T within twenty minutes of their receipt. At the B&T warehouse currently used for fulfillment, the order is processed, packaged and shipped directly to our customers. We extend a convenient return policy to our customers under which returns are shipped directly to B&T to expedite processing. Finally, providing B&T with our demand forecasts for each semester helps to ensure they maintain an adequate and relevant inventory to meet the demands of our customers.
In July 2003 B&T was purchased by a third party. Prior to this transaction, the principal owner of B&T was a private equity firm that also owned approximately a 13% of our outstanding common stock. Effective with the sale, B&T no longer shares any common ownership interests with Varsity and is not a related party.
Technology
We use an array of site management, search, customer interaction, transaction-processing and fulfillment services and systems using a combination of proprietary technologies and commercially available, licensed technologies.
Our technology environment is designed to provide:
•
a satisfying customer experience;
•
consistent system availability and good performance;
•
appropriate security for all transactions, particularly, our customers’ commerce transactions;
•
scalability for continued growth; and
•
the collection, maintenance and security of valuable information.
We currently use a Microsoft Windows operating system platform and multiple application servers that house our web servers. These servers are able to handle applications including accepting and validating customer orders, handling multiple shipment methods and accepting, authorizing and charging customer credit cards. In addition, our system maintains ongoing automated e-mail communications with customers throughout the ordering process. These systems entirely automate many routine communications, facilitate management of customer e-mail inquiries and allow customers to, on a self-service basis, check order and tracking information. We manage user requests and other traffic-using load balancing devices that work across the entire complement of our hardware. This strategy of balancing traffic allows all customers and site users to enjoy favorable response times and other performance measures, regardless of traffic fluctuations.
Substantially all of our computer and communications hardware and software systems associated with the operation of our website are located at a single secure facility owned and managed by a third party. Although we own and maintain our hardware and software systems, Qwest Communications located in Sterling, Virginia, hosts our server environment and acts as our Internet service provider and we lease the space in which our hardware system resides from Qwest. A disruption in this Internet service could cause a disruption in our ability to service our clients. We pay for the space in which our hardware system resides and our Internet access based on our usage, on a monthly basis. We may terminate this agreement on any annual renewal date without penalty.
We use the Microsoft suite of tools for our development environment, including Microsoft Visual Studio and .Net editions with SQL Server for relational database management. Additionally, we have separate database servers that capture and retain transaction “logs” of all activity that occurs on the site. These log databases can, among other things, trace a transaction from its inception to its completion. Our databases generate and deliver reports and interfaces for our marketing, operations and financial systems.
We employ SSL data encryption technology to protect credit card data while it is passed from the customer through the site during a purchase transaction. This is designed to prevent outside parties from intercepting the customer’s credit card data during transaction processing.
Textbook Competition
Online commerce, in general, and online textbooks sales, more specifically, are highly competitive markets. The number of e-commerce websites competing for customers’ attention has increased rapidly, and the market for online textbook sales is relatively new, competitive and evolving. We currently or potentially compete, directly and indirectly, for retail customers with the following categories of companies:
•
traditional new and used textbook retailers, such as campus bookstores;
•
traditional used textbook retailers, some of which have begun online selling;
•
textbook retailers and distributors such as the Follett Corporation, MBS Textbook Exchange, Nebraska Book Company, eCampus and Adams Book Company; and
•
Internet-based booksellers such as Amazon.com, Wal-Mart.com and BarnesandNoble.com.
THE VARSITY UNIFORM SOLUTION
Our uniform solution is currently focused on an attractive niche, private K-12 schools that have mandatory, exclusive products. These are products that must be purchased by every student and feature a school logo or other branding on one or multiple uniform components. The typical target school has a specific customized uniform requirement, not the broader “dress code” policies which, for example, may simply require students to wear a generic white dress shirt and khaki pants which can be purchased at any apparel retailer.
User Experience, Ordering and Delivery
Similar to our eduPartners textbook solution, our uniform solution forges exclusive relationships with schools to provide school logo embroidered uniforms to their students and families. We deliver our uniform solution to our school, parent and student customers through a number of retail channels:
•
Retail Stores - Our primary sales channel has been through nine retail stores operated by us in College Park, Maryland, Rockville, Maryland, Fairfax, Virginia, Raleigh, North Carolina, Buffalo, New York, Southfield, Michigan, Richardson, Texas, Cincinnati, Ohio, and Indianapolis, Indiana. We offer convenient hours of operation throughout the year with extended operating hours during the busy back-to-school shopping season in August and September each year. Uniform inventory is held on-site at each store and parents and students are able to purchase and take home all necessary uniform components the same day. This is currently our primary retail channel through which the majority of our revenues are recorded.
•
On Site Sales - As a further convenience to our uniform customers, we travel to eligible schools in select markets and conduct on-campus sales events during which families can purchase on-site at their school and take home all necessary uniform components the same day. During 2006, we plan to conduct approximately 100 on site uniform sales events.
•
Online Purchases - Finally, parents and students always have the ability to shop online through customized virtual stores which are created on www.campusoutfitters.com for each partner school containing all required uniform components. Orders placed online are typically picked, packed and shipped to the customer within 1-2 business days from our uniform headquarters and warehouse located in College Park, Maryland.
Customer Service
We are committed to delivering superior customer service to all of our customers, including our partner schools, parents and students. We offer extended customer service hours and increase our staffing levels during the busy back-to-school season, providing our customers convenient toll-free access to our customer service representatives and fast response to their queries. The customer service page of our website offers answers to frequently asked questions including uniform care tips, sizing charts and store locations and policies. Customers can also submit questions via e-mail.
Technology
We use an array of site management, search, customer interaction, transaction-processing and fulfillment services and systems using a combination of proprietary technologies and commercially available, licensed technologies.
Our technology environment is designed to provide:
•
a satisfying customer experience;
•
consistent system availability and good performance;
•
appropriate security for all transactions, particularly, our customers’ commerce transactions;
•
scalability for continued growth; and
•
the collection, maintenance and security of valuable information.
We are currently in the process of migrating to a new retail point-of-sale and inventory management application which we expect will be deployed to all our stores before our 2006 Fall back-to-school season. This licensed solution operates on a Microsoft Windows operating system platform with database storage at a store and enterprise level. We are also transitioning our uniform website to an integrated application with our new point-of-sale and inventory management system.
Uniform Competition
The sale of school uniforms is a mature and highly competitive market. Our uniform solution is currently focused on the sale of mandatory, school required uniform and related apparel products. All students at partner schools are typically required to purchase school approved uniform components, some of which may feature a school logo or other branding element on the garment. This target segment differs from the broader “dress code” uniform policies, for example, may simply require students to wear a generic white dress shirt and khaki pants which can be purchased at any apparel retailer.
While competitors in the broader “dress code” environment include large traditional national apparel retailers like Target and Wal-Mart, the overwhelming majority of companies competing in the customized school uniform segment which we are focused on are private, family-run businesses. We currently or potentially compete, directly and indirectly, for retail customers with the following categories of companies:
•
regional school uniform retailers, such as Dennis Uniforms, Parker School Uniforms and Flynn & O-Hara;
•
small, single market school uniform retailers;
•
traditional chain store apparel retailers such as Target, Wal-Mart and The Gap; and
•
online apparel and branded apparel retailers such as Land’s End.
INTELLECTUAL PROPERTY
We regard our trademarks, service marks, trade dress, copyrights, trade secrets, proprietary technology and similar intellectual property as important to our success. We rely on trademark and copyright law, trade secret protection and confidentiality and license agreements with our employees, customers, independent contractors, sponsors and others to protect our proprietary rights.
We may be required to obtain licenses from others to refine, develop, market and deliver new products and services. There can be no assurance that we will be able to obtain any such license on commercially reasonable terms or at all, or that rights granted pursuant to any licenses will be valid and enforceable.
Domain names are the user’s Internet “address.” Domain names have been the subject of significant trademark litigation in the United States. Domain names derive value from the individual’s ability to remember such names, therefore there can be no assurance that our domain name will not lose its value if, for example, users begin to rely on mechanisms other than domain names to access online resources.
GOVERNMENT REGULATION
Internet Regulation
There are an increasing number of laws and regulations pertaining to the Internet. Laws or regulations may be adopted relating to issues such as to liability for information retrieved from or transmitted over the Internet, online content regulation, user privacy, taxation and quality of products and services. Moreover, it may take years to determine whether and how existing laws such as those governing intellectual property ownership and infringement, privacy, libel, copyright, trade mark, trade secret, obscenity, personal privacy, taxation and the regulation of the sale of other specified goods and services apply to the Internet. The requirement that we comply with any new legislation or regulation, or any unanticipated application or interpretation of existing laws, may decrease the growth in the use of the Internet, which could in turn decrease the demand for our Internet-based services, increase our cost of doing business or otherwise materially harm our business.
Privacy Concerns
Federal, state and foreign governments have enacted or may enact laws or consider regulations regarding the collection and use of personal identifying information obtained from individuals when accessing websites, with particular emphasis on access by minors. Such regulations may include requirements that companies establish procedures to:
•
give adequate notice to consumers regarding information collection and disclosure practices;
•
provide consumers with the ability to have personal identifying information deleted from a company’s data;
•
provide consumers with access to their personal information and with the ability to rectify inaccurate information;
•
clearly identify affiliations or a lack thereof with third parties that may collect information or sponsor activities on a company’s website; and
•
obtain express parental consent prior to collecting and using personal identifying information obtained from children.
Such regulation may also include enforcement and redress provisions. While we have implemented programs designed to enhance the protection of the privacy of our users, including children, there can be no assurance that such programs will conform to applicable laws or regulations. Moreover, even in the absence of such regulations, the Federal Trade Commission has begun investigations into the privacy practices of companies that collect information on the Internet. One such investigation has resulted in a consent decree pursuant to which an Internet company agreed to establish programs to implement the privacy safeguards described above.
It is also possible that “cookies” may become subject to laws limiting or prohibiting their use. The term “cookies” refers to information keyed to a specific server, file pathway or directory location that is stored on a user’s hard drive, possibly without the user’s knowledge, and which is used to, among other things, track demographic information and to target advertising. Some of the currently available Internet browsers allow users to modify their browser settings to remove cookies or prevent cookies from being stored on their hard drives.
We currently obtain and retain personal information about our website users with their consent. We have a stringent privacy policy covering this information. However, if third persons were able to penetrate our network security and gain access to, or otherwise misappropriate, our users’ personal information, we could be subject to liability. Such liability could include claims for misuses of personal information, such as for unauthorized marketing purposes or unauthorized use of credit cards. These claims could result in litigation, our involvement in which, regardless of the outcome, could require us to expend significant financial resources.
Data Protection
Legislation pending in Congress, if passed, would afford broader rights to owners of databases of information, such as stock quotes and sports scores. Such protection already exists in the European Union. If enacted, this legislation could result in an increase in the price of services that provide data to websites. In addition, such legislation could create potential liability for unauthorized use of such data.
Internet Taxation
A number of legislative proposals have been made at the federal, state and local levels, and by foreign governments, that would impose additional taxes on the sale of goods and services over the Internet and some states have taken measures to tax Internet-related activities. Although Congress has placed a moratorium on state and local taxes on Internet access or on discriminatory taxes on e-commerce, existing state or local laws have been expressly excepted from this moratorium. Further, once this moratorium is lifted, some type of federal or state taxes may be imposed upon Internet commerce. Such legislation or other attempts at regulating commerce over the Internet may substantially impair the growth or increase the cost of commerce on the Internet and, as a result, adversely affect our opportunity to derive financial benefit from such activities.
Jurisdiction
Due to the global reach of the Internet, it is possible that, although our transmissions over the Internet originate primarily in the Commonwealth of Virginia, the governments of other states and foreign countries might attempt to regulate Internet activity and our transmissions or take action against us for violations of their laws.
EMPLOYEES
As of March 3, 2006, we had 67 full time and 12 year round part-time employees. In addition, we hire seasonal temporary employees, particularly at the beginning of the Fall school semester to support our customer service efforts, and contract service providers, particularly at during our inventory buyback program, as necessary. None of our employees are represented by a labor union or are the subject of a collective bargaining agreement. We believe that relations with our employees are good.
ITEM 1A.
ITEM 1A. RISK FACTORS
In addition to the other information in this Form 10-K, the following factors should be considered in evaluating our business and our Company. The risks and uncertainties described in this section are not the only ones facing us. Additional risks and uncertainties that we do not presently know or that we currently deem immaterial, may also impair our business, operating performance and financial condition.
WE HAVE A LIMITED OPERATING HISTORY UPON WHICH TO EVALUATE AN INVESTMENT IN OUR COMPANY.
We were founded in December 1997 and began selling textbooks on our website in August 1998. In May 2005, we acquired privately held Campus Outfitters, L.L.C. (“Campus Outfitters,”) a leading retailer of private elementary, middle and high school uniforms, which was founded in 1997 and began selling school uniforms in 1998. As a relatively new company, we face significant risks and uncertainties relating to our ability to successfully implement our strategy. If we are unable to grow as planned, our chances of maintaining profitability and the anticipated or forecasted results of operations could be reduced. You must consider the risks and uncertainties that a company with a limited operating history like ours faces. If we are unsuccessful in addressing these risks and uncertainties or are unable to execute our strategy, our business could be harmed which, in turn, could have a material adverse effect on the market price of our stock.
WE MUST CONTINUE TO CONVERT SCHOOLS TO OUR SCHOOL PROGRAMS AND RETAIN THEM IN THE PROGRAMS.
To be successful, we must attract and retain a significant number of schools to our eduPartner and Campus Outfitter school programs. Ultimately, we must attract the students and parents from each eduPartner and Campus Outfitter school to our website or retail stores at a reasonable cost. Any significant shortfall in the expected number of purchases occurring through our website or retail stores may negatively affect our financial results. Conversion of schools from traditional on campus bookstore operations to our online textbook and retail uniform outsource solutions may not occur as rapidly as we expect. Therefore, we may not achieve the customer traffic we believe is necessary to sustain the growth and profitability of our enterprise. Specific factors that could prevent widespread customer acceptance of our business and our ability to increase retail revenues include:
•
lack of awareness of our eduPartner and Campus Outfitter school programs;
•
pricing that does not meet consumer expectations;
•
consumer concerns about the security of online transactions;
•
shipping charges, which do not apply to shopping at traditional retail stores and are not always charged by some of our online competitors;
•
the delivery time associated with online orders, as compared to the immediate receipt of products at traditional retail stores;
•
product damage from shipping or shipments of the wrong products, which may result in a failure to establish trust in purchasing our products online;
•
delays in responses to consumer inquiries or in deliveries to consumers; and
•
difficulty in returning or exchanging orders.
Based on these or other factors, we may not be able to retain existing eduPartners or Campus Outfitter member schools or sign-up new eduPartners or Campus Outfitter member schools.
WE PRIMARILY RELY ON ONE SUPPLIER TO MEET OUR TEXTBOOK FULFILLMENT NEEDS.
We depend on B&T as the primary supplier of the textbooks that we offer. Our relationship with B&T is critical to our success. Our current contract with B&T expires on June 30, 2008. If we are unable to renew this contract when it expires, or are unable to otherwise rely on B&T for inventory maintenance and shipping services and we are unable to open our own distribution center or establish a comparable vendor relationship before the B&T relationship discontinues, our business may be materially harmed.
B&T warehouses most of our textbook inventory and we rely on them to maintain adequate inventory levels and rapidly fill our customers’ orders. Prices we pay for promotional, customer service and database management services and credits that we receive from B&T are currently based on volume and average cost requirements. Failure to meet these benchmarks would increase our costs. If they do not maintain sufficient inventory, or if they are unable to deliver the specific books our customers order or deliver these books in a timely fashion, we would not be able to meet our obligations to our customers, our revenues would decrease and we would likely experience a reduction in the value of our brand. If our relationship with B&T is disrupted or does not continue for any reason and we are unable to establish a comparable vendor relationship or open our own warehouse before the B&T relationship discontinues, we would not be able to fulfill our customers’ textbook orders. We cannot be certain that we would be able to establish new vendor relationships to ensure acquisition and distribution of textbooks in a timely and efficient manner or on acceptable commercial terms. In such event, we may determine that we need to maintain inventory, establish warehouse facilities and provide distribution services, which would require us to change our business model.
In addition, we estimate that a single publisher represented approximately 17% of our textbook revenues in 2005. If B&T’s relationship with this publisher is disrupted or discontinued, our business may be harmed.
We benefit from the shipping discounts offered to B&T by UPS and we rely on UPS and other third party common carriers for all shipments to and from B&T. If B&T’s relationship with UPS is discontinued or disrupted for any reason, we cannot be certain
we would be able to affordably obtain comparable delivery services and might not be able to deliver textbooks to our customers in a timely manner. In addition, because we rely on third party common carriers to ship products to and from the B&T warehouses that our fulfillment is currently conducted from, we are subject to the risks, including employee strikes and inclement weather, that may prevent such third parties from meeting our fulfillment and delivery needs. Failure to deliver products to our customers in a timely and accurate manner may harm our reputation, our brand and our business.
WE FACE SIGNIFICANT COMPETITION IN THE ONLINE TEXTBOOK MARKETS AND THAT COMPETITION MAY INCREASE SUBSTANTIALLY BECAUSE OF THE LOW BARRIERS TO MARKET ENTRY.
The e-commerce and online textbook markets are new, rapidly evolving and intensely competitive. We expect competition to intensify in the future. Barriers to entry in the e-commerce industry are minimal, and current and new competitors can launch new websites quickly and at a relatively low cost. In addition, new and expanded Internet technologies, including search and web services, may further increase competition in the online textbook and e-commerce industries. We currently compete with a variety of other companies in the sale of textbooks, and if we are able to add other online product or service offerings we will have additional competition in those markets. Our current and potential competition in the textbook market includes the following categories of companies:
•
traditional new and used textbook retailers, such as campus bookstores;
•
traditional used textbook retailers, some of which have begun online selling;
•
textbook retailers and distributors such as the Follett Corporation, MBS Textbook Exchange, Nebraska Book Company, eCampus and Adams Book Company; and
•
Internet-based booksellers such as Amazon.com, Wal-Mart.com and BarnesandNoble.com
We are not able to reliably estimate the number of our direct competitors. To date, our most active competitor targeting the private middle and high school textbook market with an online bookstore program is MBS Textbook Exchange. Many of our current and potential competitors have longer general retail operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing, technological, operational and other resources than we do. Some of our competitors may be able to secure textbooks from vendors on more favorable terms, devote greater resources to marketing and promotional campaigns, adopt more aggressive pricing, shipping policies or inventory availability policies and devote substantially more resources to website and systems development than we can. As competition increases, we may experience reduced operating margins from pricing pressure or higher customer acquisition and retention costs, loss of market share and a diminished brand franchise.
To remain competitive, we may from time to time make pricing, service or marketing decisions or acquisitions that could negatively affect our financial condition and results of operations. It is possible that our supply channel (distributors and, indirectly, publishers) may enter the market and match our pricing through direct retail centers. Either or both of our supply channel or traditional operators of school bookstores may enter the online commerce market as our competitors.
As Internet use becomes increasingly prevalent, it is possible that the full text of books we offer for sale will be available for viewing on the web or on other electronic devices such as virtual textbooks. If virtual textbooks become a reality and students rely on them in lieu of purchasing hard copies of textbooks, our business may decline.
WE RELY ON OUR GOOD RELATIONSHIPS WITH VENDORS TO PURCHASE UNIFORM AND APPAREL MERCHANDISE AT FAVORABLE PRICES. IF THESE RELATIONSHIPS WERE TO BE IMPAIRED, WE MAY NOT BE ABLE TO OBTAIN A SUFFICIENT SELECTION OF MERCHANDISE AT ATTRACTIVE PRICES, WHICH COULD HAVE A NEGATIVE IMPACT ON OUR COMPETITIVE POSITION, OUR BUSINESS AND FINANCIAL PERFORMANCE.
We do not have long-term supply agreements or exclusive arrangements with any of our uniform and apparel vendors and, therefore, our success in the school uniform retail market depends on maintaining good relations with them. Since our business is fundamentally dependent on selling merchandise at attractive prices, we must continue to obtain from our vendors a wide selection of this merchandise at favorable wholesale prices. Our growth strategy depends to a significant extent on the willingness and ability of our vendors to supply us with sufficient inventory to stock our stores. If we fail to continue to deepen and strengthen our relations with our existing vendors to improve the quality of merchandise they supply us we may limit our ability to obtain a sufficient amount and variety of merchandise at favorable prices, which could have a negative impact on our competitive position.
WE PRIMARILY RELY ON ONE MANUFACTURER FOR CERTAIN MATERIALS REQUIRED BY SOME OF OUR CAMPUS OUTFITTER SCHOOLS.
Some of our Campus Outfitter program schools require uniforms with specific fabric and design requirements. We believe that suitable materials for these school uniforms could be obtained from other manufacturers in the event that our regular supplier (because of financial difficulties or otherwise) is unable or fail to provide them. However, there could be a significant production
delay or disruption caused by the inability of the current supplier to deliver these materials which would make it difficult to identify and utilize alternative suppliers quickly, which in turn could have a material adverse impact on our results of operations. If we did experience any such delays or interruptions, there is no assurance that we would be able to find adequate alternative suppliers at a reasonable cost or without significant disruption to our business.
YOU SHOULD NOT RELY ON OUR QUARTERLY OPERATING RESULTS AS AN INDICATION OF OUR FUTURE RESULTS BECAUSE THEY ARE SUBJECT TO SIGNIFICANT FLUCTUATIONS.
Our quarterly operating results may fluctuate significantly in the future due to a variety of factors that could affect our revenues or our expenses in any particular quarter. We expect to continue to experience significant seasonality in our business related to the academic calendar and the corresponding demand for textbooks, uniforms and educational materials. Due to the concentration of private middle and high schools in our eduPartners and Campus Outfitters school programs, our revenues are concentrated in the traditional Fall back-to-school season of July, August and September, our third calendar quarter. During the third quarter of 2005, 2004, and 2003 our revenues were approximately 86%, 85% and 85 % of total annual revenues, respectively. We expect this trend to continue. Fluctuations in our quarterly operating results could cause our stock price to decline. You should not rely on sequential quarter-to-quarter comparisons of our results of operations as an indication of future performance. Factors that may affect our quarterly results include:
•
seasonal trends in the textbook and school uniform industry and in the buying habits of students;
•
concentration of private middle and high schools in our eduPartners and Campus Outfitters school programs;
•
our ability to manage or influence inventory and fulfillment operations;
•
the level of merchandise returns we experience;
•
our ability to attract new customers, retain existing customers, maintain customer satisfaction and respond to our competitors;
•
introduction of enhancements or a change in pricing policies, by us or our competitors, or a change in pricing policy by our fulfillment sources in either the textbook or school uniform industries;
•
changes in the amount and timing of expenditures related to marketing, information technology and other operating expenses to support future growth;
•
technical difficulties or system downtime affecting the Internet generally or the operation of our website specifically;
•
potential acquisitions or strategic alliances either by us or our competitors;
•
general economic conditions, economic conditions specific to the Internet, eCommerce or the textbook and uniform industries; and
•
our ability to adequately staff our retail locations.
As a result of the seasonal fluctuations and because the online sale of textbooks and online selling in general is relatively new and it is difficult to predict consumer demand, it is possible that in some future periods our results of operations may be below the expectations of public market analysts and investors. In that event, it is likely that the price of our stock would decline.
OUR BUSINESS HAS EXPERIENCED SIGNIFICANT GROWTH OVER THE LAST THREE FISCAL YEARS. CONTINUED GROWTH AT THE LEVELS WE HAVE EXPERIENCED OUR LAST THREE FISCAL YEARS WILL PLACE A STRAIN ON OUR MANAGEMENT, OPERATIONAL AND FINANCIAL RESOURCES.
Our total revenues and total employees have grown over 200% over our last three years. We are rapidly expanding our operations and will continue to expand further to pursue growth of our core eduPartners business and expand into new markets, as evidenced by the acquisition of Campus Outfitters in May 2005. Such growth increases the complexity of our business and places a significant strain on our management, operations, and financial resources, and there can be no assurance that we will be able to manage it effectively. Our current and planned personnel, systems, procedures, and controls may not be adequate to support and effectively manage our future operations. We may not be able to hire, train, retain, motivate, and manage required personnel, which may limit our growth. If any of this were to occur, it could damage our reputation, limit our growth, adversely affect our operating results and harm our business.
WE FACE SIGNIFICANT INVENTORY RISK WITH OUR TEXTBOOKS.
Our textbook inventory balance as of December 31, 2005 consisted mainly of:
•
New textbook inventory held at B&T, our fulfillment partner, acquired by B&T in support of our eduPartners program for which they generally do not enjoy standard return privileges with publishers and new textbooks held at Campus Outfitters retail locations and at other locations; and
•
Used textbooks held at B&T, Campus Outfitters retail locations, or other locations.
Under our agreement with B&T in which B&T provides our order fulfillment and drop shipment services, B&T assumes ownership of all new textbooks until shipment and does not assume ownership of the used products it processes for us. Approximately 90% of new textbook unsold inventory at B&T is returned for credit with our publishers, which substantially reduces our risk of inventory obsolescence, however, we take title to the remaining unsold inventory and write down this balance for estimated excess and obsolete or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions on a quarterly basis.
Should textbook return privileges extended to B&T or us by publishers materially change, we may face increased inventory risk and higher working capital requirements which could adversely affect our operating results.
To the extent that we continue to procure used textbooks and maintain textbook inventory at our Campus Outfitter retail operations, we will face increased inventory risk, which may adversely affect our operation results.
LOSS OF ANY OF OUR KEY MANAGEMENT PERSONNEL OR THE INABILITY OF OUR KEY MANAGEMENT PERSONNEL TO WORK TOGETHER EFFECTIVELY OR SUCCESSFULLY MANAGE OUR GROWTH COULD NEGATIVELY AFFECT OUR BUSINESS.
Our future success depends to a significant extent on the continued service and coordination of our management team, particularly Eric J. Kuhn, our co-founder and Chairman of the Board, Mark F. Thimmig, our President and Chief Executive Officer as of February 15, 2006, and Jack M Benson, our Chief Financial Officer. We have entered into agreements with Mr. Kuhn, Mr. Thimmig and Mr. Benson that provide, among other things, that they are compensated in the event they are terminated without cause. The loss or departure of any of our executive officers or key employees could harm our ability to implement our business plan. We do not maintain key person insurance on any member of our management team.
IF WE ARE UNABLE TO ADAPT AS INTERNET TECHNOLOGIES AND CUSTOMER DEMANDS CONTINUE TO EVOLVE, OUR SERVICES AND PRODUCTS COULD BECOME LESS DESIRABLE.
The satisfactory performance, reliability and availability of our website, transaction-processing systems and network infrastructure are critical to our reputation and our ability to attract and retain customers and maintain adequate customer service levels. An unanticipated dramatic increase in the volume of traffic on our website or the number of orders placed by our customers may force us to expand and upgrade our technology, transaction-processing systems and network infrastructure. There can be no assurance that we will be able to accurately project the rate or timing of increases, if any, in the use of our website or timely expand and upgrade our systems and infrastructure to accommodate such increases. To be successful, we must adapt to our rapidly changing market by continually enhancing the technologies used in our Internet products and services and introducing new technology to address the changing needs of our business and customers. If we are unable, for technical, legal, financial or other reasons, to adapt in a timely manner in response to changing market conditions or business and customer requirements, our business could be harmed.
We are currently upgrading our information systems, which includes substantially all aspects of transaction processing, including order management, cash and credit card processing, purchasing, inventory management and shipping in order to accommodate the Campus Outfitters acquisition, the continued growth of our textbook program, and to comply with the numerous reporting and control requirements imposed by the Sarbanes Oxley Act, including Section 404. Our success, in particular our ability to successfully receive and fulfill orders and provide high-quality customer service, largely depends on the efficient and uninterrupted operation of our computer and communications hardware systems. We launched the first phase of the upgraded new system in our second quarter of fiscal 2004, however, the systems upgrades were complex. This complexity can make it difficult to detect errors or failure in our website prior to implementation. We may not immediately discover errors in our new system until the volume of orders placed by our customers significantly increases from the levels we experienced in our last fall back to school season. As a result, the upgraded website may not achieve the expected benefits. Unanticipated problems with our website may result in customer dissatisfaction, a loss of, or delays in, the market acceptance of our website, and lost revenue and collection difficulties during the period required to correct these errors. Failure to correct these problems may harm our reputation, our brand and our business.
WE DEPEND ON A THIRD-PARTY SERVICE PROVIDER FOR OUR INFORMATION TECHNOLOGY INFRASTRUCTURE. IF OUR THIRD-PARTY SERVICE PROVIDER EXPERIENCES ANY SYSTEM FAILURE OR INADEQUACY, OUR OPERATIONS COULD BE JEOPARDIZED.
Our operations are dependent on our ability to maintain our computer and communications software and equipment in effective working order and to protect our systems against damage from fire, natural disaster, power loss, communications failure or similar events. In addition, the growth of our customer base may strain or exceed the capacity of our computer and communications systems and lead to degradations in performance or systems failure. Our success, in particular our ability to successfully receive and fulfill orders and provide high-quality customer service, largely depends on the efficient and
uninterrupted operation of our computer and communications hardware systems. We use an internally developed system for our website, search engine and substantially all aspects of transaction processing, including order management, cash and credit card processing, purchasing, inventory management and shipping.
Substantially all of our computer and communications hardware and software systems associated with the operation of our website are located at a single facility in Sterling, Virginia. That facility is owned, maintained and serviced by Qwest Communications. Although we own and maintain our hardware and software systems, including the software which is central to the sales, ordering and shipping processes, we rely on Qwest to ensure our computer and communications hardware and software operate efficiently and continuously. We do not presently have fully redundant systems or a formal disaster recovery plan and do not carry sufficient business interruption insurance to compensate for losses that may occur. Communications circuits, including access to and from the Internet are currently supplied by Qwest Communications. A disruption in this Internet service could cause a disruption in our ability to service our clients.
Despite our implementation of network security measures, our servers are vulnerable to computer viruses, physical or electronic break-ins, fire, flood, power loss, telecommunications failure, break-ins, earthquake and similar disruptions, which could lead to interruptions, delays, loss of data or the inability to accept and fulfill customer orders. Any damage, failure or delay that causes interruptions in our system operations could have a material adverse effect on our business.
In addition to our offsite software and hardware related to our website, at our headquarters we maintain a local area network, or LAN, which we use for our financial reporting systems, customer service operations, monitoring of our customer orders, e-mails and other internal processes. Any loss of service or other failure of this LAN, regardless of the availability of our website, would significantly impair our ability to service our customers and monitor and fulfill customer orders, which could have a material adverse effect on our business.
The failure of either our website or our LAN or any other systems interruptions that results in unavailability of our website or reduced order fulfillment performance, especially during the peak Fall sales period of July/August/September, could result in negative publicity or could reduce the volume of goods sold and attractiveness of our website and would seriously impair our ability to service our customers’ orders, all of which could negatively affect our revenues. Because our servers are located at a third-party’s facility and because some of the reasons for a systems interruption may be outside of our control, we also may not be able to exercise sufficient control to remedy the problem quickly or at all. Regardless of whether we or a third-party controls or creates system failure, the occurrence of system failure could adversely affect our reputation, seriously harm our business and cause us to lose a significant and disproportionate amount of revenues.
CONCERNS ABOUT SECURITY ON THE INTERNET MAY REDUCE THE USE OF OUR WEBSITE AND IMPEDE OUR GROWTH.
A significant barrier to confidential communications over the Internet has been the need for security. We rely on SSL encryption technology designed to prevent the misappropriation of customer credit card data during the transaction process. Under current credit card practices, a merchant is liable for fraudulent credit card transactions where, as is the case with the transactions we process, that merchant does not obtain a cardholder’s signature. A failure to adequately control fraudulent credit card transactions could reduce our collections and harm our business. Internet usage could decline if any well-publicized compromise of security occurred. Our site could be particularly affected by any such breach because our online commerce model requires the entry of confidential customer ordering, purchasing and delivery data over the Internet, and we maintain a database of this historical customer information. Until more comprehensive security technologies are developed, the security and privacy concerns of existing and potential customers may inhibit the growth of the Internet as a medium for commerce. We cannot be certain that advances in computer capabilities, new discoveries in the field of cryptography or other developments will not result in the compromise or breach of the algorithms we use to protect content and transactions on our website or proprietary information in our databases. Anyone who is able to circumvent our security measures could misappropriate proprietary, confidential customer or company information or cause interruptions in our operations. We may incur significant costs to protect against the threat of such security breaches or to alleviate problems caused by these breaches.
WE MAY BECOME SUBJECT TO BURDENSOME GOVERNMENT REGULATIONS AND LEGAL UNCERTAINTIES AFFECTING THE INTERNET THAT COULD ADVERSELY AFFECT OUR BUSINESS.
To date, governmental regulations have not materially restricted use of the Internet in our markets. However, the legal and regulatory environment that pertains to the Internet is uncertain and may change. Uncertainty and new regulations could increase our costs of doing business and prevent us from delivering our products and services over the Internet. The growth of the Internet may also be significantly slowed. This could delay growth in demand for our online services and limit the growth of our revenues. In addition to new laws and regulations being adopted, existing laws may be applied to the Internet. New and existing laws may cover issues, which include:
•
sales and other taxes;
•
user privacy;
•
pricing controls;
•
characteristics and quality of products and services;
•
consumer protection;
•
libel and defamation;
•
copyright, trademark and patent infringement; and
•
other claims based on the nature and content of Internet materials.
THE SARBANES OXLEY ACT OF 2002 IMPOSES ADDITIONAL OBLIGATIONS ON US, INCLUDING THE REQUIREMENT THAT WE DOCUMENT AND EVALUATE OUR INTERNAL CONTROLS. THIS EXERCISE HAS NO PRECEDENT AVAILABLE BY WHICH TO MEASURE THE ADEQUACY OF OUR COMPLIANCE AND MAY RESULT IN NON- COMPLAINCE WHICH MAY ADVERSLY AFFECT OUR STOCK PRICE. EFFORTS TO COMPLY WILL RESULT IN ADDITIONAL OPERATING EXPENSES, WHICH MAY MATERIALLY AFFECT OUR FINANCIAL RESULTS.
The Sarbanes-Oxley Act of 2002 and newly proposed or enacted rules and regulations of the SEC and NASDAQ impose new duties on us and our executives, directors, attorneys and independent accountants. In order to comply with the Sarbanes-Oxley Act and such new rules and regulations, we are evaluating our internal controls systems to allow management to report on, and our independent registered public accounting firm to attest to, our internal controls over financial reporting. It is uncertain as to which fiscal year we will need to comply with Section 404 of the Sarbanes-Oxley Act, although it is possible that it could be applicable to us for our December 31, 2006 Form 10-K. We expect that our efforts to comply with these new regulations will result in significant increases in general and administrative expenses in fiscal 2006 as we may be required to hire additional personnel and use additional outside legal, accounting and advisory services. Additionally, we expect that our efforts to prepare to comply with these new regulations will also result in a diversion of management time and attention from operating activities to compliance activities. Any of these developments could materially increase our operating expenses or affect our operating performance, which would adversely affect financial results.
While we anticipate being able to fully implement the requirements relating to the Sarbanes-Oxley Act in a timely fashion, we cannot be certain as to the outcome of our testing and resulting remediation actions or the impact of the same on our operations since there is no precedent available by which to measure compliance adequacy. If we are not able to implement the requirements of the Sarbanes-Oxley Act in a timely manner or with adequate compliance, we may be subject to sanctions or investigation by regulatory authorities, such as the SEC or NASDAQ, and our reputation may be harmed. Any such action could adversely affect our financial results and may adversely affect out stock price. Moreover, because these laws, regulations and standards are subject to varying interpretations, their application in practice may evolve over time as new guidance becomes available. This evolution may result in continuing uncertainty regarding compliance matters and additional costs necessitated by ongoing revisions to our disclosure and governance practices.
NEW ACCOUNTING PRONOUNCEMENTS MAY NEGATIVELY IMPACT OUR STOCK PRICE.
In December 2004, the Financial Accounting Standards Board, issued Statement of Financial Accounting Standards, or SFAS, No. 123R, “Share-Based Payment.” This statement, which is effective in our first quarter of 2006, changes how we account for share-based compensation and may negatively impact our stock price. The impact of adoption of SFAS No. 123R is difficult to predict at this time because it will depend on levels of share-based payments granted in the future. However, we believe if we had adopted SFAS No. 123R in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the notes to our consolidated financial statements. SFAS No. 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow. This requirement will reduce our net operating cash flows and increase our net financing cash flows in periods after adoption.
OUR ACQUISITION OF CAMPUS OUTFITTERS MAY ADVERSELY AFFECT OUR COMBINED FINANCIAL RESULTS IN FUTURE YEARS.
On May 26, 2005, we completed our first acquisition, acquiring substantially all of the assets of Campus Outfitters, a leading retailer of private elementary, middle and high school uniforms. As a result, we incurred acquisition and integration costs which contributed to a decrease in income before taxes. Although we expect the acquisition to be accretive to our earnings in fiscal 2006 and beyond, we may experience additional unforeseen integration expenditures or we may not realize expected synergies between our businesses. If this happens, our financial results may be adversely affected.
WE MAY ENCOUNTER PROBLEMS EFFECTIVELY INTEGRATING CAMPUS OUTFITTERS.
Acquisitions involve the integration of companies that have previously operated independently. In connection with the Campus Outfitters acquisition, there can be no assurance that we will:
•
effectively integrate employees, operations, products and systems;
•
realize the expected benefits of the transaction;
•
retain key employees;
•
realize all expected synergies;
•
avoid unanticipated operational difficulties or expenditures or both; and
•
effectively operate our existing textbook business, given the significant diversion of resources and management attention required to successfully integrate Campus Outfitters.
In addition to the risks described above the ultimate success of our acquisition of Campus Outfitters is dependent on factors which include the following:
•
our ability to retain and motivate Campus Outfitter key employees;
•
our ability to fulfill our strategic plan for the acquisition of Campus Outfitters; and
•
our ability, together with Campus Outfitters, to cross-sell our products between our respective client bases.
IF WE ACQUIRE ANY ADDITIONAL COMPANIES IN THE FUTURE, THEY COULD PROVE DIFFICULT TO INTEGRATE, DISRUPT OUR CORE BUSINESS, DILUTE SHAREHOLDER VALUE AND ADVERSELY AFFECT OUR OPERATING RESULTS.
We evaluate and enter into negotiations pertaining to possible acquisitions, strategic investments in businesses and joint ventures in the ordinary course of our business. New acquisitions or investments may be disruptive to our organization. In connection with any acquisitions or investments, there is no assurance that we will:
•
effectively integrate operations, technologies, services and personnel;
•
avoid a diversion of financial and managerial resources from existing operations;
•
avoid assumption of unknown liabilities;
•
avoid unanticipated operational difficulties or expenditures or both;
•
retain key employees;
•
generate sufficient revenue to offset acquisition or investment costs; and
•
realize the expected benefits of the transaction.
In addition, any future acquisition or investment may result in a dilution to existing shareholders to the extent we issue shares of our common stock as consideration or reduced liquidity and capital resources to the extent we use cash as consideration.
OUR CAMPUS OUTFITTER BUSINESS DEPENDS IN PART ON THE AVAILABILITY OF SUITABLE LEASE SPACE TO SELL ITS SCHOOL UNIFORMS.
Through our Campus Outfitters brand, we sell school uniforms to the private K-12 school marketplace at retail locations in Indiana, Maryland, Michigan, North Carolina, New York, Ohio, Texas and Virginia. Part of our future growth is dependent on our ability to continue to operate these stores in desirable locations with lease costs that allow us to earn a reasonable return. One retail location is currently leased month-to-month and the other retail locations have leases that are scheduled to expire between January 2007 and May 2015. There can be no assurance that we will be able to renew our current leases as they expire, or that new leases will be available on terms acceptable to us. Failure to renew expiring leases may harm our reputation, our brand and our business.
IF WE DO NOT SUCCESSFULLY OPERATE OUR CAMPUS OUTFITTER RETAIL LOCATIONS, OUR BUSINESS COULD BE HARMED.
If we do not successfully operate our Campus Outfitter retail locations, our ability to meet customer demand could be significantly limited. Because our business model has not depended on sales from retail locations in the past, we may not manage our retail facilities in an optimal way, which may result in an excess or insufficient amount of inventory at our retail locations. A failure to optimize inventory in our retail locations will increase our shipping costs, by requiring us to make additional shipments to or from retail locations or vendors. We may be unable to adequately staff our retail locations. As we expand our retail customer base, our fulfillment network may become increasingly complex and operating it will become more challenging. There can be no assurance that we will be able to operate our fulfillment network effectively.
AS INTERNET TECHNOLOGY AND REGULATION ADVANCES, WE MAY NOT BE ABLE TO PROTECT OUR DOMAIN NAMES.
We currently hold various Internet domain names relating to our brands, including the “VarsityBooks.com”, “VarsityGroup.com”, “Varsity-Group.com” and “CampusOutfitters.com” domain names. Governmental agencies and their designees generally regulate the acquisition and maintenance of domain names. The regulation of domain names in the generic category of domain names (i.e., .com, .net and .org) is now controlled by a non-profit corporation, which may create additional top-level domains. Requirements for holding domain names have also been affected. As a result, there can be no assurance that we will be able to acquire or maintain relevant domain names. Furthermore, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights. Any such inability could harm our business.
SOME STATES MAY IMPOSE A NEW SALES TAX ON OUR BUSINESS.
A 1992 Supreme Court decision held that the Commerce Clause of the United States Constitution limits a state’s ability to impose a sales or use tax collection responsibility on an out-of-state vendor unless such vendor maintains a physical presence, i.e., substantial nexus, in the taxing state. Based on this Supreme Court decision, we have determined that we do not have a substantial nexus in some jurisdictions where our products are received by customers, and, therefore, do not collect or remit sales or use tax in such jurisdictions. Because the scope of the 1992 Supreme Court decision is unclear, states may challenge our determination of substantial nexus. If successful, such challenges could result in significant liabilities for sales and use taxes with a material and adverse effect on our business. We currently collect and remit sales or use tax on all shipments to eighteen states. The 1992 Supreme Court decision also established that Congress has the power to enact legislation that would permit states to require collection of sales and use taxes by mail-order companies. Congress has from time to time considered proposals for such legislation. We anticipate that any legislative change, if adopted, would be applied on a prospective basis. While there is no case law on the issue, we believe that this analysis could also apply to our online business. Recently, several states and local jurisdictions have expressed an interest in taxing e-commerce companies who do not have any contacts with their jurisdictions other than selling products online to customers in such jurisdictions.
OUR EXECUTIVE OFFICERS, DIRECTORS AND EXISTING STOCKHOLDERS, WHOSE INTERESTS MAY DIFFER FROM OTHER STOCKHOLDERS, HAVE THE ABILITY TO EXERCISE SIGNIFICANT CONTROL OVER US.
As of December 31, 2005, our executive officers, directors and entities affiliated with them, in the aggregate, owned approximately 21% of our outstanding common stock. These stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors, the approval of significant corporate transactions and the power to prevent or cause a change of control. The interests of these stockholders may differ from the interests of our other stockholders.
IF WE ARE UNABLE TO MAINTAIN OUR NASDAQ NATIONAL MARKET LISTING, OUR COMMON STOCK MAY BE SUBJECT TO DELISTING FROM THE NATIONAL MARKET AND YOUR ABILITY TO TRADE SHARES OF OUR COMMON STOCK COULD SUFFER.
In September 2004, our common stock was approved for relisting on the NASDAQ National Market and began trading on the NASDAQ National Market on September 29, 2004. For our common stock to remain listed on the NASDAQ National Market, we must meet the minimum listing requirements for continued listing, including, among other requirements, minimum bid price and market value of public float requirements. If we fail to continue to meet the minimum listing requirements, we may be delisted from the NASDAQ National Market. If our common stock is delisted from the NASDAQ National Market, sales of our common stock would likely be conducted only in the over-the counter market. This may have a negative impact on the liquidity and the price of our common stock, and investors may find it more difficult to purchase or dispose of, or to obtain accurate quotations as to the market value of, our common stock.
THE TRADING PRICE FOR OUR COMMON STOCK MAY DROP AND THIS COULD AFFECT YOUR ABILITY TO RESELL YOUR SHARES AT OR ABOVE THE PRICE YOU PAID TO PURCHASE SUCH SHARES.
The stock market, in general, and the trading prices of shares in public technology companies, particularly those such as ours that offer Internet-based products and services, have experienced extraordinary price and volume volatility in recent years. Such volatility has adversely affected the stock prices for many companies irrespective of, or disproportionately to, the operating performance of these companies. Indeed, the trading price of our common stock dropped significantly during the year ended December 31, 2000, thereby precipitating our delisting from the NASDAQ National Market in March 2001. Alternatively, the trading price of our common stock rose significantly during the years ended December 31, 2003 and 2004, ultimately leading to our common stock being relisted on the NASDAQ National Market in September 2004. During the year ended December 31,
2005, the trading price of our common stock dropped significantly. We believe that these fluctuations in our stock prices could be the result of many factors, some of which are beyond our control, such as:
•
our quarterly or annual results in operations;
•
investor perception of us, online retailing services and retail store services in general;
•
general economic conditions both in the United States and in foreign countries;
•
adverse or favorable business developments;
•
futures sales of substantial amounts of our common stock by our existing shareholders, officers or directors;
•
failure to meet estimates or expectations of securities analysts or changes in financial estimates by securities analysts; and
•
announcements by us or our competitors of new products and services.
As a result of these factors, we cannot assure you that the trading price of our common stock will not drop again or stay at its current price. Market and industry factors may materially and adversely further affect the market price of our common stock, regardless of our actual operating performance. Significant decreases in the trading price of our common stock is likely to affect our visibility and credibility in our market and this could affect your ability to resell your shares at or above the price you paid to purchase such shares.
IF OUR STOCK PRICE IS VOLATILE, WE MAY BECOME SUBJECT TO SECURITIES LITIGATION WHICH IS EXPENSIVE AND COULD RESULT IN A DIVERSION OF RESOURCES.
Securities class action litigation has often been brought against companies that experience volatility in the market price of their securities. Litigation brought against us could result in substantial costs to us in defending against the lawsuit and a diversion of management’s attention that could cause our business to be harmed.
FUTURE SALES OF OUR COMMON STOCK MAY NEGATIVELY AFFECT OUR STOCK PRICE.
The market price of our common stock could decline as a result of sales of a large number of shares of our common stock by our existing shareholders, officers or directors, or the perception that such sales could occur. These sales also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate.
IT MAY BE DIFFICULT FOR A THIRD PARTY TO ACQUIRE OUR COMPANY AND THIS COULD DEPRESS OUR STOCK PRICE.
Delaware corporate law and our amended and restated certificate of incorporation and our by-laws contain provisions that could have the effect of delaying, deferring or preventing a change in control of Varsity Group or a change of our management that stockholders may consider favorable or beneficial. These provisions could discourage proxy contests and make it more difficult for you and other stockholders to elect directors and take other corporate actions. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions include those which:
•
authorize the issuance of “blank check” preferred stock, which is preferred stock that can be created and issued by the board of directors without prior stockholder approval, with rights senior to those of common stock;
•
provide for a staggered board of directors, so that it would take three successive annual meetings to replace all directors;
•
prohibit stockholder action by written consent; and
•
establish advance notice requirements for submitting nominations for election to the board of directors and for proposing matters that can be acted upon by stockholders at a meeting.
ITEM 2.
ITEM 2. PROPERTIES
Our headquarters is located at 1850 M Street, Suite 1150, Washington, D.C. We currently lease approximately 69,000 square feet pursuant to thirteen leases that are month-to-month or are scheduled to expire between June 2006 and May 2015.
Location
Use
Square Feet
1300 19th Street, Suite 800, Washington, D.C.
Office Space - New Headquarters
16,000
1850 M Street, Suite 1150 Washington, D.C.
Office Space - Old Headquarters
6,500
5112 Berwyn, Rd College Park, MD
Office Space / Warehouse
16,850
5107A College Park, MD
Warehouse
2,425
5107E College Park, MD
Warehouse
1,975
New York, NY
Office Space
Rockville MD
Retail Store
1,175
Fairfax, VA
Retail Store
1,400
Raleigh, NC
Retail Store
1,175
Cincinnati, OH
Retail Store
5,700
Indianapolis, IN
Retail Store
6,825
Williamsville, NY
Retail Store
3,000
Southfield, MI
Retail Store
5,000
Richardson, TX
Retail Store
2,825
On March 31, 2006, we entered into a four-year lease agreement for a new headquarters facility at 1300 19th Street, Suite 800, Washington, D.C. for approximately 16,000 square feet to replace our existing headquarters facilities at 1850 M Street, Washington, D.C., which expires in May 2006. We moved into our new headquarters space during our second quarter of fiscal 2006. We expect our total obligation to be approximately $2.5 million over the four-year term of the lease.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are a party to various legal proceedings and claims incidental to our business. Management does not believe that the resolution of any such matters that are pending as of the date of this report will have a material adverse effect on the results of operations or financial condition of our company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock was traded on the NASDAQ National Market under the symbol VSTY from February 15, 2000 until March 20, 2001. Beginning on March 21, 2001 our common stock traded on the OTC Bulletin Board under the symbol VSTY.OB until September 29, 2004 when our stock was relisted on the NASDAQ National Market trading under the symbol VSTY where it continues to trade as of the date of this report. Prior to February 15, 2000, our common stock was not publicly traded.
For the period from January 1, 2004 to December 31, 2005, the high and low closing prices per share of our common stock were as follows:
As of March 6, 2006, there were 181 stockholders of record, excluding the number of beneficial owners whose shares were held in street name. On March 6, 2006, the closing price of our common stock as reported on the NASDAQ National Market was $4.08 per share. We believe that the number of beneficial holders is significantly in excess of such amount based on the security position listings we obtain from time to time for the purpose of facilitating mailings to our stockholders.
We have never declared or paid any cash dividends on our common stock. Any decision regarding the declaration of future cash dividends will be made by our Board of Directors in their discretion.
There were no share repurchases of our commons stock during fiscal 2005. As of March 31, 2006, the Company had repurchased a total of 1,215,397 shares.
The information required by this item regarding equity compensation plans is incorporated herein by reference from the information contained in Item 12 of this Form 10-K.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data presented below as of and for the fiscal years ended December 31, 2005, 2004, 2003, 2002 and 2001 have been derived from our audited consolidated financial statements. This data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations, our Consolidated Financial Statements and Notes thereto, and other financial information appearing elsewhere in this Form 10-K.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward Looking Statements
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this annual report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties that could cause our actual results to differ materially. These statements relate to future events or our future financial performance and are based on information available to us as of the date hereof, and we assume no obligation to update any forward-looking statement. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “except,” “plan,” “anticipate,” “intend,” “seek,” “expect,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms or other comparable terminology. These statements are only predictions. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to, those discussed in “Risk Factors” included elsewhere in this annual report on Form 10-K and other reports and filings made with the Securities and Exchange Commission.
The following discussion provides additional information to the accompanying consolidated financial statements and notes to help provide an understanding of our financial condition, changes in financial condition and results of operations. This discussion is organized as follows:
•
Overview. This section provides a general description of our business, economic and industry-wide factors relevant to us and material opportunities, challenges and risks in our business.
•
Critical Accounting Policies. This section discusses those accounting policies that contain uncertainties and require significant judgment in their application.
•
Results of Operations. This section provides an analysis of our results of operations for all three years presented in the accompanying consolidated statements of operations.
•
Liquidity and Capital Resources. This section provides an analysis of our sources and uses of cash, capital expenditures and the amount of financial capacity available to fund our future commitments.
OVERVIEW
We are a leading retailer of textbooks, educational materials and school uniforms targeting the private middle and high school, college, distance, and continuing education markets. Under the “VarsityBooks” and “Campus Outfitters” brands, we offer a comprehensive outsource solution to provide textbooks, uniforms and school supplies to private K-12 schools, colleges, and distance and continuing education markets. Through our textbook and uniform outsource solutions, schools are released from the operational and financial challenges associated with managing highly seasonal retail operations and are free to focus on their core educational mission. Parents and students benefit from the increased convenience and value associated with our comprehensive textbook and uniform programs.
We were incorporated in December 1997 and began offering books for sale on our website on August 10, 1998. Prior to 2005, our revenues consisted primarily of sales of new textbooks. In May 2005, we acquired Campus Outfitters, a leading retailer of school uniforms to the private K-12 school marketplace, and introduced school uniforms as a second revenue stream into our business. To date, the primary channel for textbook sales has been through online eCommerce transactions, while the majority of uniform sales have been recognized through retail stores and on-campus sales events.
Our original sales model focused on building a broad consumer brand offering promotions and deeply discounted textbook prices to entice college students to visit our website and purchase their textbooks from us. However, during 2000 we began to focus resources on the growth and development of our eduPartners program, whereby we became a provider of new textbooks and learning materials to private middle and high school, college, distance, and continuing education markets. This model represents the overwhelming majority of our textbook business today.
Fiscal 2002 marked a significant milestone for us as we recorded the first profitable fiscal year in our company. This was accomplished through a combination of revenue growth, margin enhancement and cost reduction efforts initiated during 2000. As part of this transformation we successfully lowered our overall expense structure and improved the margins of our retail book business while growing eduPartners revenues.
In May 2005, as part of our strategy to expand the number of services and products we offer our customers, we acquired Campus Outfitters. Through the Campus Outfitters brand, Varsity Group owns and operates nine retail locations serving private K-12
school communities as their official school uniform provider. Parents and students are also able to purchase uniforms and related items via on-campus sales events which are held at eligible schools as well as online through customized virtual stores which are created on www.campusoutfitters.com for each partner school containing all required uniform components. We believe with the Campus Outfitters acquisition, we now have the opportunity to begin cross-selling our textbook and uniform model between our combined network of existing customers.
During 2005, in part due to organic growth through our eduPartners program and in part due to the acquisition of Campus Outfitters, overall revenues grew by $12.4 million, or 32.9%, to $50.1 million, from $37.7 million in fiscal 2004. Fiscal 2005 also represented our fourth consecutive profitable fiscal year.
We expect textbooks and uniforms/apparel to remain our primary sources of revenue in 2006. However, we will continue to explore opportunities to expand the scope of products and services we provide our partner schools and will aggressively pursue opportunities which we believe will enable us to introduce new, profitable revenue streams.
Our ability to sustain annual operating profitability depends on our ability to maintain and grow net revenues while containing expenses. We base our current and future expense levels on our operating plans and estimates of future revenues. In view of the rapidly evolving nature of our business and our limited operating history, we have limited experience forecasting our revenues. Therefore we believe that period-to-period comparisons of our financial results might not necessarily be meaningful and you should not rely on them as an indication of future performance.
Seasonality
We experience significant seasonality in our results of operations. Consistent with our focus on the expansion of eduPartners and introduction of Campus Outfitters uniform model and their current concentration of private middle and high school institutions, since the year ended December 31, 2000, our peak selling period is the July/August/September back-to-school season. During fiscal 2005 and 2004, approximately 86% and 85% of our revenues, respectively, were recognized in this period. We expect this trend to continue as we expand our textbook and uniform programs in the private middle and high school market during 2006. While many private middle and high school institutions have an active book buying season in December/January, the volume of purchases are typically significantly lower than the initial back-to-school season. Historically, Campus Outfitters has experienced the same seasonality in its results of operations. Consistent with its current concentration of private elementary, middle and high schools, Campus Outfitters peak selling season has been July/August/September back-to-school season. Part of our strategy is to extend our textbook program more deeply into the college and distance learning markets, expand our uniform model to more broadly incorporate branded apparel and identify profitable new products or services to market to our existing customer base. This could result in more balanced revenues throughout the year. However, based upon our current program, product and school mix, we will continue to experience significant fluctuations in quarterly operating results. Please see “Forward-Looking Statements.”
CRITICAL ACCOUNTING POLICIES
Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States. For a comprehensive discussion of our accounting policies, see Note 2 in the accompanying consolidated financial statements included in this Annual Report on Form 10-K. We do not have any ownership interest in any special purpose or similar entities and do not have any significant related party transactions except for those associated with our relationship with B&T prior to July 2003. See Note 3 to the consolidated financial statements.
Pursuant to guidance published by the SEC regarding disclosure about critical accounting policies, we have identified the following accounting policies as critical to the understanding of our financial statements.
Revenue Recognition
We recognize revenue from textbook and uniform sales, net of any discounts and coupons, when our customers receive the products. We take title to new textbooks sold online via our eduPartners program upon transfer to the shipper and assume the risks and rewards of ownership including the risk of loss for collection. We take title to our uniform and textbook inventory held at our retail locations at the time of purchase from the supplier, publisher or buyback customer and we place them in inventory as available for sale at that time. We do not function as an agent or broker for our supplier (see Note 3 to the consolidated financial statements). Outbound shipping charges are included in net sales. We provide allowances for sales returns, promotional discounts and coupons based on historical experience in the period of the sale. Through May 2005, our revenues have consisted primarily of sales of textbooks. After our acquisition of Campus Outfitters in May 2005, our revenues have consisted of sales of textbooks and uniforms.
Deferred Income Taxes
We account for income taxes in accordance with Statement of Financial Accounting Standards No. 109 (“SFAS 109”), “Accounting for Income Taxes.” Under SFAS No. 109, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. In determining the need for a valuation allowance, management reviews both positive and negative evidence pursuant to the requirements of SFAS No. 109, including current and historical results of operations, the annual limitation on utilization of net operating loss carryforwards pursuant to Internal Revenue Code Section 382, future income projections and the overall prospects of our business. Based upon management’s assessment of all available evidence, including our cumulative net income for fiscal 2003, 2004 and 2005, estimates of future profitability and the overall prospects of our business, we concluded that it is more likely than not that the recorded portion of the deferred tax benefits will be realized. We will continue to monitor all available evidence and reassess the potential realization of our deferred tax assets on an annual basis, coinciding with our fiscal year end, or on an interim basis if circumstances change. If we continue to meet our financial projections and improve upon our results of operations, it is reasonably possible that we may release all, or a portion, of the remaining valuation allowance in the future. Such releases, if any, would result in recording a tax benefit that would increase net income in the period the allowance is released and, thereafter, if relating to certain option deductions, increase additional-paid-in-capital. At December 31, 2005, approximately $6.9 million of potential future income tax benefit was fully reserved on our consolidated financial statements.
Stock-Based Compensation Plans
Through December 31, 2005, we accounted for our stock-based compensation plans in accordance with Accounting Principles Board (“ABP”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations using the intrinsic value based method of accounting (see “Recent Accounting Standards.” We estimate that if we used the fair value method outlined by Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation,” and Statement of Financial Accounting Standards No. 148 (“SFAS 148”), “Accounting for Stock-Based Compensation - Transition and Disclosure,” our reported amounts of net income would have been reduced by approximately $5.7 million, $1.9 million and $0.7 million for the years ended December 31, 2005, 2004 and 2003 respectively. Our reported amounts of net income per diluted share would have been reduced by approximately $0.30, $0.10 and $0.04 for the years ended December 31, 2005, 2004 and 2003, respectively. The determination of the fair value of our equity options includes significant estimates, such as volatility and expected terms. See Note 2 to the consolidated financial statements.
Valuation of Inventories
Inventories, consisting of textbooks and uniforms available for sale, are valued at the lower of cost or market value and are accounted for principally using the FIFO method. Our inventory balance as of December 31, 2005 consists mainly of used textbooks that we purchased during fiscal 2005, new textbooks that we are able to procure from publishers at better terms than those available to B&T, and uniforms or apparel, and new and used textbooks located at our retail locations. Historically, approximately 90% of the unsold new textbook inventory held by B&T in support of our eduPartners program has been returned for full credit with publishers, which substantially reduces our risk of inventory obsolescence. We take title to the remaining unsold inventory and write down this balance, as well as any remaining used book inventory, for estimated excess and obsolete or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value, based upon assumptions about future demand and market conditions on a quarterly basis.
In connection with our acquisition of Campus Outfitters, we acquired approximately $2.6 million in apparel inventory. In accordance with Statement of Financial Accounting Standards No. 141 “Business Combinations” (“SFAS 141”), we valued the acquired inventory based on estimated selling prices less the sum of a reasonable profit allowance for our selling effort and costs of disposal.
Business Acquisition and Valuation and Impairment Review of Long-Lived Assets
We accounted for our purchase of Campus Outfitters in accordance SFAS 141 and accounted for the related acquired intangible assets in accordance with Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets” (“SFAS 142”). In accordance with SFAS 141, we allocated the cost of Campus Outfitters to the identifiable tangible and intangible assets and liabilities assumed, with the remaining amount being classified as goodwill. Management’s estimates of the fair value of the identifiable intangible assets acquired was based on discounted cash flow techniques that included significant estimates about future performance. As required by SFAS 142, in lieu of amortizing goodwill, we will test goodwill for impairment annually and any time a triggering indicator exists. The determination of the value of such intangible assets and the annual impairment tests required by SFAS 142 requires management to make estimates of future revenues, customer retention rates, estimated useful lives and other assumptions that affect our consolidated financial statements.
We assess the impairment of long-lived assets, including software developed for internal use, in accordance with Statement of Financial Accounting Standards No. 144 (“SFAS 144”) “Accounting for the Impairment of Long-Lived Assets,” whenever events or changes in circumstances indicate that the carrying value may not be fully recoverable. When we determine that the
carrying value of such assets may not be recoverable, we generally measure any impairment based on a projected discounted cash flow method using a discount rate determined by management to be commensurate with the risk inherent in our current business model. In addition, at each reporting date, we compare the net realizable value of capitalized software development costs to the unamortized capitalized costs. To the extent the unamortized capitalized costs exceed the net realizable value, the excess amount is written off. In accordance with SFAS 144, we recorded a write-off of approximately $15,000 during the fiscal year ended December 31, 2005 related to the discontinued use of our buyback program software, which has been replaced with another tool.
Evaluating long-lived assets for impairment involves judgments as to when an asset may potentially be impaired. We consider there to be a risk of impairment if there is a significant decrease in the market value of an asset or if there is a significant change in the extent or intended use of an asset.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 2005 COMPARED TO YEAR ENDED DECEMBER 31, 2004
Net Sales
Net sales increased 32.9%, or $12.4 million, to $50.1 million for year ended December 31, 2005. Uniform revenue introduced with our acquisition of Campus Outfitters in May 2005 represented approximately $5.8 million of this increase. The remaining increase of $6.6 million was due to the growth of textbook and related revenues attributable to the increase in the number of schools we serviced during 2005 compared to the prior year period.
Net sales consist of sales of textbooks and uniforms and charges to customers for outbound shipping and are net of allowances for returns, promotional discounts and coupons. Revenues from sales are recognized at the time products are received by the customer. In 2006, we expect our total revenues to increase based upon the continued growth of our VarsityBooks eduPartners textbook and Campus Outfitters school uniform programs. Over time, expansion of used book revenue as a percentage of total revenues may serve to lower textbook revenue growth since used books are typically priced at a 25% discount to comparable new
textbooks. However, the related decrease in revenue growth is typically offset by higher gross margins associated with the sale of used books. See “Forward Looking Statements.”
Operating Expenses
Cost of Textbooks
Cost of textbooks consists of the cost of textbooks and related education material sold to customers. Cost of textbooks increased 20.7%, or approximately $4.8 million, to approximately $28.2 million for the year ended December 31, 2005. This increase was attributable to our increased sales volume. Expressed as a percentage of related revenue, cost of textbooks was 69.5% for the year ended December 31, 2005, compared to 67.9% for the year ended December 31, 2004. This increase was attributable, in part, to increased inventory and related obsolescence costs associated with our expansion to a second distribution center located in Reno, Nevada this year, deeper ordering in support of our eduPartners program and increased costs associated with textbook sales through our Campus Outfitter retail stores. Cost of textbooks varies with textbook revenue and we expect these costs to increase in absolute dollars as our customer base and number of eduPartners served expands. Please see “Forward-Looking Statements.”
Cost of Uniforms
Cost of uniforms consists of the cost of uniforms and apparel sold to customers. Cost of uniforms was approximately $2.6 million for the year ended December 31, 2005. Expressed as a percentage of related revenue, cost of uniforms was 45.9% for the year ended December 31, 2005. Cost of uniforms varies with uniform revenue and we expect these costs to increase in absolute dollars as our customer base expands. Please see “Forward-Looking Statements.”
Cost of Shipping
Cost of shipping consists of outbound shipping to our customers. Cost of shipping increased 13.4%, or approximately $0.3 million, to approximately $2.9 million, for the year ended December 31, 2005. This increase was attributable to our increased sales volume. Expressed as a percentage of related revenue, cost of shipping was 78.8% for the year ended December 31, 2005 compared to 77.9% for the year ended December 31, 2004.
Certain aspects of our agreements with B&T provide for the assignment of separate values to the separate services provided by them: supply of books, shipping and other services, including website content and customer database management. Such assignment is based on the relative fair value of each element as determined by B&T. Consequently, we have included in “cost of textbooks” in our statement of operations the cost of purchased books from B&T, we have included in “cost of shipping” the cost of shipping charges from B&T and we have included in sales and marketing the cost of other services including website content and customer database management charged from B&T.
Sales and Marketing
Sales and marketing expense consists primarily of promotional expenditures, credit card processing fees, travel expense, expenses associated with contracting with our eduPartners schools, expenses associated with our Campus Outfitters retail locations and road shows, seasonal overhead associated with performing inventory purchases at eduPartner schools, and payroll and related expenses for personnel engaged in sales and marketing, account management, eduPartners operations and Campus Outfitters operations. Sales and marketing expense increased 59.8%, or approximately $3.5 million, to approximately $9.3 million for the year ended December 31, 2005. The increase during fiscal 2005 was attributable to increased costs associated with the acquisition of Campus Outfitters, increased credit card processing fees associated with higher absolute sales levels, an increase in expenses for payments to our program schools based upon increased sales levels and increases in payroll and related expenses and other costs resulting from an increase in the number of staff dedicated to sales and marketing, account management and operations compared to the prior year period.
The following table sets forth sales and marketing expense for the years ended December 31, 2005 and 2004 (in thousands):
Variable sales and marketing expense consists of credit card expenses, certain expenses associated with contracting with our eduPartners and Campus Outfitters schools, and sales expenses associated with our agreement with B&T. During fiscal 2005, variable sales and marketing expense increased 27.8%, or approximately $1.0 million, to approximately $4.7 million from the comparable year period. This increase was attributable to our revenue growth. We expect that variable sales and marketing expense will continue to increase at levels consistent with growth in the number of schools we service. Please see “Forward-Looking Statements.”
Other sales and marketing expense consists of primarily of payroll and related expenses for personnel engaged in sales and marketing, account management, eduPartners operations and Campus Outfitters operations, travel expense, expenses associated with our Campus Outfitters retail locations and road shows and seasonal overhead associated with performing inventory purchases at eduPartner schools. During fiscal 2005, fixed sales and marketing expense increased 114.8%, or approximately $2.5 million, to approximately $4.6 million from the comparable year period. We anticipate that other sales and marketing expenses will continue to increase in absolute dollars as we expand operations to support expected short and longer-term revenue growth. Please see “Forward-Looking Statements.”
General and Administrative
General and administrative expense consists of payroll and related expenses for executive, administrative, and our development and systems personnel, facilities expenses, costs associated with the upgrade and maintenance of our website, outside consultant and professional services expenses, travel, and other general corporate expenses. General and administrative expense, reported net of $0.7 million and $0.8 million of costs capitalized for software developed for internal use for fiscal 2005 and 2004, respectively, increased 52.0%, or approximately $1.7 million, to approximately $4.9 million for the year ended December 31, 2005 compared to the prior year period. The net increase was primarily attributable to increased costs associated with our acquisition of Campus Outfitters in May 2005, an increase in maintenance costs associated with the costs we have capitalized in prior periods for software developed for internal use and general increases in personnel and infrastructure expenditures associated with the growth of our business.
We are capitalizing costs associated with our website upgrade in accordance with American Institute of Certified Public Accountants (“AICPA”) Statement of Position No. 98-1 (“SOP 98-1”), “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” We began to amortize the capitalized costs on our balance sheet as of June 30, 2004 on a straight-line basis beginning in our third quarter of fiscal 2004 when the website was placed into service, and we will continue to capitalize the costs of new functionality related to the website upgrade during fiscal 2006 in accordance with SOP 98-1.
We will continue to upgrade our information systems in fiscal 2006, which includes substantially all aspects of transaction processing, including order management, cash and credit card processing, purchasing, inventory management and shipping in order to accommodate the Campus Outfitters acquisition, the continued growth of our textbook program, and to comply with the numerous reporting and control requirements imposed by the Sarbanes Oxley Act, including Section 404. Therefore, we anticipate incurring significant increases in general and administrative expenses in fiscal 2006. Please see “Forward-Looking Statements.”
Amortization of Acquired Intangibles.
Our acquisition of Campus Outfitters in May 2005 was accounted for under the purchase method of accounting. As a result, we recorded intangible assets at their applicable fair values of the net tangible assets acquired. Intangible assets are amortized over periods ranging from three to ten years. Amortization of intangibles was approximately $0.1 million during fiscal 2005. See Note 10 to the consolidated financial statements.
Non-Cash Compensation
Non-cash compensation expense consists of expenses related to previous year grants of employee options based on the intrinsic value of the stock option. Non-cash compensation was $40,000 for the year ended December 31, 2004. The deferred non-cash compensation expense was fully amortized as of September 30, 2004.
Other Income (Expense), net
Other income (expense), net consists primarily of interest income on our cash and cash equivalents and investments. Other income was $0.5 million for the year ended December 31, 2005, compared to $0.3 million for the year ended December 31, 2004. The increase in fiscal 2005 as compared to the prior year period was due to higher average interest rates.
Income Taxes
Income tax benefit for the years ended December 31, 2005 and 2004 was approximately $9.5 million and $3.8 million, respectively. We account for income taxes in accordance with SFAS 109. Under SFAS No. 109, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. In determining the need for a valuation allowance, management reviews both positive and negative evidence pursuant to the requirements of SFAS No. 109, including current and historical results of operations, the annual limitation on utilization of net operating loss carry forwards pursuant to Internal Revenue Code section 382, future income projections and the overall prospects of our business. During fiscal 2005 and 2004, management reassessed the potential realization of its remaining valuation allowance based on its financial projections, estimates of future profitability and the overall prospects of our business and concluded that it was more likely than not that a portion of the recorded deferred tax benefits would be realized. Consequently, we released $10.0 million and $5.0 million of the valuation allowance in fiscal 2005 and 2004, respectively, which has resulted in a tax benefit during both years compared to an expected combined federal and state statutory tax rate of approximately 38.9% and 38.0%, respectively. The deferred tax benefits of $10.0 million and $5.0 million recorded in 2005 and 2004, respectively, were offset by income tax provisions of approximately $0.5 million and $1.2 million related to pre-tax income recorded in fiscal 2005 and 2004, respectively. At December 31, 2005 and 2004, we had net operating loss carryforwards for federal income tax purposes of approximately $57.3 million and $60.3 million, respectively, which expire beginning in 2018.
We will continue to monitor all available evidence and reassess the potential realization of our deferred tax assets. If we continue to meet our financial projections and improve upon our results of operations, it is reasonably possible that we may release all, or a portion, of the remaining valuation allowance in the future. Any such release would result in recording a tax benefit that would increase net income in the period the allowance is released. Please see “Forward-Looking Statements” and Note 15 to the consolidated financial statements.
YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDED DECEMBER 31, 2003
Net Sales
Net sales increased 49.3%, or $12.4 million, to $37.7 million for the year ended December 31, 2004, driven by higher textbook and shipping revenues as a result of the continued growth and development of our eduPartners program. The increase in overall revenues is largely attributed to the continued growth of eduPartners during 2004.
Net sales consist primarily of sales of textbooks books and charges to customers for outbound shipping and are net of allowances for returns, promotional discounts and coupons. Revenues from sales of textbooks are recognized at the time products are received by the customer.
Operating Expenses
Cost of Product
Cost of product consists primarily of the cost of textbooks. Cost of product sold to customers increased 47.7%, or $7.5 million, to $23.3 million for the year ended December 31, 2004. This increase was primarily attributable to our increased sales volume. Expressed as a percentage of related revenue, cost of products was 67.9% and 68.9%, for the years ended December 31, 2004 and 2003, respectively.
Cost of Shipping
Cost of shipping consists of outbound shipping. Cost of shipping increased 73.3%, or $1.1 million, to $2.5 million for the year ended December 31, 2004. This increase was attributable to our increased sales volume. Expressed as a percentage of related revenue, cost of shipping was 77.9% and 64.5% for the years ended 2004 and 2003, respectively. The increase in shipping costs in 2004 was attributable to an increase in third party shipping rates and fuel surcharges in 2004 compared to 2003, which we did not pass on to our customers.
Certain aspects of our agreements with B&T provide for the assignment of separate values to the separate services provided by them: supply of books, shipping and other services, including website content and customer database management. Such assignment is based on the relative fair value of each element as determined by B&T. Consequently, we have included in “cost of product” in our statement of operations the cost of purchased books from B&T, we have included in “cost of shipping” the cost of shipping charges from B&T and we have included in sales and marketing the cost of other services including website content and customer database management charged from B&T.
Sales and marketing
Sales and marketing expense consists primarily of promotional expenditures, credit card processing fees, travel expense, expenses associated with contracting with our eduPartners schools, seasonal overhead associated with performing inventory purchases at eduPartner schools, and payroll and related expenses for personnel engaged in sales and marketing, account management and eduPartners operations. Sales and marketing expense increased 48.3%, or approximately $1.9 million, to approximately $5.8 million for the year ended December 31, 2004, compared to the same period in 2003. The increases in 2004 were attributable to higher costs associated with sales and marketing fees related to our agreement with B&T, increased credit card processing fees associated with higher sales levels as well as increases in payroll and related expenses and other expenses resulting from an increase in the number schools in our eduPartners program and the number of employees compared to the prior year period. Contributing to the increase in the year ended December 31, 2004 were the seasonal costs associated with performing inventory purchases of used books at eduPartner schools for the first time during our second quarter fiscal 2004.
Specified sales and marketing expenses associated with our agreement with B&T are the product of the classification of services such as website content and customer database management as sales and marketing expense and we expect these costs will continue to increase in absolute dollars as we expand our business. These expenses increased to $2.1 million for the year ended December 31, 2004 from $1.4 million for the year ended December 31, 2003.
Tax related benefit
During the year ended December 31, 2003, we recorded a negative tax related expense of $0.5 million. This tax related expense was attributable to the release of earlier sales tax related tax accruals recorded primarily between 1999 and 2001. No similar benefit was recorded in fiscal 2004.
General and Administrative
General and administrative expense consists of payroll and related expenses for executive, administrative, and our development and systems personnel, facilities expenses, costs associated with the upgrade and maintenance of our website, outside consultant and professional services expenses, travel, and other general corporate expenses. General and administrative expense, reported net of $0.8 million of costs capitalized for software developed for internal use during fiscal 2004, increased 44.0%, or approximately $1.0 million, to approximately $3.2 million for the year ended December 31, 2004 compared to the prior year period. This increase was due to an increase in personnel and infrastructure expenditures needed to support the growth of our business as well as increased expenses associated with the relisting of our common stock on the NASDAQ National Market on September 29, 2004.
We are capitalizing costs associated with our website upgrade in accordance with American Institute of Certified Public Accountants (“AICPA”) Statement of Position No. 98-1 (“SOP 98-1”), “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” We began to amortize the capitalized costs on our balance sheet as of June 30, 2004 on a straight-line basis beginning in our third quarter of fiscal 2004 when the website was placed into service.
Non-Cash Compensation
Non-cash compensation expense consists of expenses related to previous grants of employee options based on the intrinsic value of the stock option. Non-cash compensation expense decreased to approximately $40,000 for the year ended December 31, 2004, compared to approximately $216,000 for the prior year period. The deferred non-cash compensation expense was fully amortized as of September 30, 2004.
Other Income (Expense), net
Other income (expense), net consists primarily of interest income on our cash and cash equivalents and investments. Other income was $312,000 and $241,000 for the years ended December 31, 2004 and 2003, respectively. This increase was due to higher average cash invested in long-term investments and higher average interest rates during the year ended December 31, 2004.
Income Taxes
Income tax benefit for the years ended December 31, 2004 and 2003 was approximately $3.8 million and $2.0 million, respectively. We account for income taxes in accordance with SFAS 109. Under SFAS No. 109, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. In determining the need for a valuation allowance, management reviews both positive and negative evidence pursuant to the requirements of SFAS No. 109, including current and historical results of operations, the annual limitation on utilization of net operating loss carry forwards pursuant to Internal Revenue Code section 382, future income projections and the overall prospects of our business.
During fiscal 2004 and 2003, management reassessed the potential realization of its remaining valuation allowance based on its financial projections, estimates of future profitability and the overall prospects of our business and concluded that it was more likely than not that a portion of the recorded deferred tax benefits would be realized. Consequently, we released $5.0 million and approximately $2.9 million of the valuation allowance in fiscal 2004 and 2003, respectively, which has resulted in a tax benefit during both years compared to an expected effective tax rate of approximately 38.8%. The deferred tax benefits of $5.0 million and approximately $2.9 million recorded in 2004 and 2003, respectively, were offset by income tax provisions of $1.2 million and $0.9 million related to pre-tax income recorded in fiscal 2004 and 2003, respectively. At December 31, 2004 and 2003, we had net operating loss carryforwards for federal income tax purposes of approximately $60.3 million and $59.8 million, respectively, which expire beginning in 2018.
LIQUIDITY AND CAPITAL RESOURCES
As of December 31, 2005, we had $6.1 million of cash, cash equivalent and short-term investments in auction rate marketable securities and net working capital of approximately $14.6 million compared to approximately $11.9 million of cash, cash equivalents and short-term investments and net working capital of approximately $14.2 million at December 31, 2004. The decrease in cash, cash equivalents and short-term investments during 2005 was primarily attributable to cash payments for the Campus Outfitters acquisition and related liabilities, collection of certain rebates and receivables from B&T that were not realized until our first quarter of fiscal 2006, and cash payments to acquire used textbooks during our fiscal 2005 buyback campaign. As of December 31, 2005, our principal commitments consisted of obligations outstanding under accrued liabilities, accounts payable and operating leases. During 2005, we continued to upgrade our internally developed system for our website. In 2006, we expect to experience significant expenditures related to ongoing systems and infrastructure upgrades. We also expect additional increases in our capital expenditures and lease commitments consistent with anticipated growth in operations and personnel.
Net cash (used in) provided by operating activities was $(2.5) million, $0.2 million and $1.8 million during the years ended December 31, 2005, 2004 and 2003, respectively. The change in operating cash flows of $(2.7) million during the year ended December 31, 2005 from the prior year period was due to:
•
an increase in other current assets related to deposits we had with B&T; and
•
an increase in accounts receivable associated with the increase in revenues recorded in fiscal 2005.
These decreases were partially offset by an increase in net income, partially offset by the tax benefit associated with the release of a portion of the valuation allowance against deferred tax assets.
The change in operating cash flows of $(1.6) million during the year ended December 31, 2004 from the prior year period was due to:
•
an increase in inventory associated with a large scale inventory buyback of used textbooks, the procurement of used textbooks from third party wholesalers and the operations of two on-campus bookstores during the year ended December 31, 2004;
•
an increase in other current assets related to deposits we had with B&T; and
•
an increase in accounts receivable associated with the increase in revenues recorded in fiscal 2004, compared to the prior year period.
These decreases were partially offset by an increase in net income, partially offset by the tax benefit associated with the release of a portion of the valuation allowance against deferred tax assets as well as increases in taxes payable and accounts payable in the year ended December 31, 2004 compared to the prior year period.
Investing activities consist of acquisitions of businesses, capitalization of software developed for internal use, purchases of property, plant and equipment, purchases of software, and purchases and sales of short-term and long-term investments. Net cash provided by (used in) investing activities was $74,000, $4.0 million, and $(1.8) million during the years ended December 31, 2005, 2004 and 2003, respectively. During the year ended December 31, 2005, we used approximately $3.1 million cash for the acquisition of Campus Outfitters and had total purchases of property, equipment and software, including capitalization of software, of approximately $1.0 million, primarily due to our initiative to upgrade our internal software system for our website. During the year ended year ended December 31, 2005, we sold approximately $4.1 million of short-term and long-term investments.
During 2004, cash provided by investing activities consisted primarily of the net sales of $12.0 million in short-term investments partially offset by net purchases of approximately $7.0 million of long-term investments and $1.0 million of purchases of property, equipment and software, including capitalization of software, an increase of approximately $0.8 million over the
comparable period in 2003 due to our initiative to upgrade our internal software system for our website. During 2003, cash used in investing activities consisted primarily of the purchases of short-term investments, net of sales.
Net cash provided by (used in) financing activities was $0.3 million, $(0.3) million and, $(0.2) million for the years ended December 31, 2005, 2004 and 2003, respectively. Net cash provided by financing activities in 2005 consisted of $0.3 million cash proceeds from the exercise of stock options and warrants. Net cash used in financing activities in 2004 consisted of $0.5 million cash used to purchase treasury shares, partially offset by proceeds from the exercise of stock options and warrants. Net cash used in financing activities during 2003 consisted of $0.7 million cash used to purchase treasury shares, partially offset by net proceeds from the exercise of stock options and warrants.
Commitments
With our acquisition of Campus Outfitters in May 2005, we assumed capital and operating leases for certain equipment and vehicles used in the normal course of business, lease obligations for nine retail stores and two warehouses, and nominal amounts of other purchase obligations. Operating lease arrangements are sometimes referred to as a form of off-balance sheet financing. We do not use off-balance sheet arrangements with unconsolidated entities; accordingly, our liquidity and capital resources are not subject to off-balance sheet risks from unconsolidated entities. We do have an off-balance sheet arrangement with a related party for our College Park, Maryland retail and warehouse lease. See Note 17 to the consolidated financial statements.
The following table provides an overview of our aggregate contractual obligations and the effect these obligations are expected to have on our liquidity and cash flows in future periods are as follows (in thousands):
(1) Includes payments made through April 2006 for month-to-month leases.
(2) On March 31, 2006, we entered into a four-year lease agreement for a new headquarters facility at 1300 19th Street, Suite 800, Washington, D.C. for approximately 16,000 square feet. This lease will replace our existing headquarters facilities at 1850 M Street, Washington, D.C., which expires in May 2006. We moved into our new headquarters space during our second quarter of fiscal 2006. Our expected total cash obligation to be approximately $2.5 million over the full four-year term of the lease is included. See Note 19.
As of the date of this filing, we lease approximately 69,000 square feet pursuant to thirteen leases that are month-to-month or are scheduled to expire between May 2006 and May 2015.
We intend to increase spending on the development of our eduPartners and Campus Outfitters school programs and related infrastructure, the Campus Outfitters integration, and we anticipate incurring additional increases in general and administrative expenses fiscal 2006 as we take more of the necessary steps to prepare to comply with the numerous reporting and control requirements imposed by the Sarbanes-Oxley Act, including Section 404. Failure to generate sufficient revenues or, if necessary, reduce discretionary spending could harm our results of operations and financial condition. Please see “Forward-Looking Statements.”
We are currently considering, and may pursue in the future, additional acquisitions of complementary businesses. In addition, we may make strategic investments in businesses and enter into joint ventures that complement our existing business strategy. Any future acquisition or investment may result in a dilution to existing shareholders to the extent we issue shares of our common stock as consideration or reduced liquidity and capital resources to the extent we use cash as consideration.
We believe that our existing liquidity and expected cash flows from operations will satisfy the capital requirements of our current business for the foreseeable future. We believe that the combination of cash, cash equivalents, short-term and long-term investments and anticipated cash flows from operations will be sufficient to fund expected capital expenditures, capital lease obligations and working capital needs associated with our current business model for at least the next twelve months. See “Forward Looking Statements.”
RECENT ACCOUNTING STANDARDS
In November of 2004, FASB issued Statement No 151, “Inventory Costs”, an amendment of Accounting Research Bulletin No. 43, Chapter 4 (“SFAS 151”). The amendments made by SFAS 151 clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The guidance is effective for inventory costs incurred during the fiscal year beginning January 1, 2006. We do not believe that the adoption of the new standard will have a material impact on our financial position.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which replaces SFAS No. 123 and supercedes APB Opinion No. 25 and requires all share-based payments to employees and directors, including grants of employee and director stock options, to be recognized in the financial statements based on their fair values. We are required to adopt SFAS 123R in the first quarter of 2006.
Through December 31, 2005, we accounted for share-based payments to employees and directors using the intrinsic value method. Under this method, we generally did not recognize any compensation related to stock option grants we issued under our equity compensation plans. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition.
Beginning in our first quarter 2006, SFAS 123R requires us to recognize share-based compensation as compensation expense in the statement of operations based on the fair values of such equity on the date of the grant, with the compensation expense recognized over the period in which the recipient is required to provide service in exchange for the equity award. This statement also requires us to adopt a fair value-based method for measuring the compensation expense related to share-based compensation. We plan to use the modified-prospective method of recognition of compensation expense related to share-based payments, which requires that compensation expense be recorded for all unvested stock options and restricted stock from the beginning of the first quarter of adoption of SFAS 123R. The impact of adoption of SFAS 123R is difficult to predict at this time because it will depend on levels of share-based payments granted in the future. However, management currently estimates that, based on our unvested stock option awards outstanding as of December 31, 2005, the remaining compensation cost related to previous grants that will be recognized in the financial statements pursuant to the modified prospective method in future years will be approximately $0.2 million.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”). Under SFAS 154, entities will be required to report a change in accounting principle through retrospective application of the new accounting principle to all prior periods, unless impracticable to do so. In addition, errors in the financial statements of a prior period discovered subsequent to their issuance shall be reported as a prior period adjustment by restating the prior period financial statements. This standard will be effective for accounting changes and corrections of errors made, if any, in fiscal years beginning after December 15, 2005. Management does not believe the adoption of this standard will have a material impact on our financial position in 2006.
In October 2005, the FASB issued FASB Staff Position FAS 123 (R)-2, “Practical Accommodation to the Application of Grant Date as Defined in FASB Statement No. 123(R)” (“FSP 123R-2”). FSP 123R-2 requires companies to estimate the fair value of share based payment awards when the award has been granted. One of the criteria for determining that an award has been granted is that the employer and its employees have a mutual understanding of the key terms and conditions of the award. Under FSP 123 R-2, a mutual understanding is assumed to exist on the date the award is approved by the Board of Directors and the key terms and conditions of the award are expected to be communicated to the individual within a relatively short time period from the date of approval. We are required to adopt FSP 123R in the first quarter of 2006.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to market risk for the effect of interest rate changes and changes in the market values of our investments.
Interest Rate Risk. Our cash equivalents, short-term investments and long-term investments are subject to interest rate risk. We manage this risk by maintaining a diversified investment portfolio of instruments with high credit quality and varying maturity dates. These instruments are designated as available-for-sale and, accordingly, are presented at fair value on our balance sheets and include, but are not limited to, commercial paper, money-market instruments, bank time deposits and variable rate and fixed rate obligations of corporations and national, state and local governments and agencies. These instruments are denominated in U.S. dollars. The fair market value of cash equivalents, short-term investments and long-term investments held was $12.5 million and $18.9 million at December 31, 2005 and December 31, 2004, respectively. We also hold cash balances in accounts with commercial banks in the United States. These cash balances represent operating balances only and are invested in short-term deposits of the local bank.
The weighted average yield on interest-bearing investments held as of December 31, 2005 was approximately 3.7% per annum. Based on our investment holdings at December 31, 2005, a 100 basis point decline in the average yield would have reduced our annual interest income by $0.1 million.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our financial statements required by Regulation S-X are included herein beginning on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES [TBD]
Evaluation of Disclosure Controls and Procedures
As required by Rule 13a-15 under the Securities Exchange Act of 1934, management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in our reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding our required disclosure. In designing and evaluating our 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 is required to apply its judgment in evaluating and implementing possible controls and procedures.
As described below, management identified a material weakness in our internal control over financial reporting. The Public Company Accounting Oversight Board’s Auditing Standard No. 2 defines a material weakness as a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. As a result of the material weakness, our Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2005, the end of the period covered by this report, our disclosure controls and procedures were not effective at a reasonable assurance level.
Specifically, we did not maintain effective controls over the accuracy of the calculation of earnings per share. Effective controls were not designed and in place over the calculation of diluted shares outstanding for purposes of calculating diluted earnings per share. This control deficiency resulted in a computational error of the number of shares to be assumed as repurchased in the application of the treasury stock method that was not prevented or detected. The source of the error was an error in the functioning of a spreadsheet used to make the underlying computations. Although this error did not affect total revenues, expenses or net income, it understated the dilutive effect of stock options granted in determining the weighted average common shares by overstating the number of shares eligible for repurchase under the treasury method consistent with Financial Accounting Standard Board Statement No. 128, “Earnings Per Share” and, therefore, overstating diluted earnings per share (but not net income) reported in certain prior periods in which we reported a net profit. This control deficiency resulted in an audit adjustment to the 2005 annual consolidated financial statements prior to their public release. Additionally, this control deficiency could have resulted in a misstatement of earnings per share that would have resulted in a material misstatement to annual or interim financial statements that would not have been prevented or detected. Accordingly, management has determined that this control deficiency constitutes a material weakness.
As a result of the material weakness described above, we performed additional analysis and other post-closing procedures which included the recalculation of all share amounts used in the earnings per share calculation to ensure that the consolidated financial statements were prepared in accordance with generally accepted accounting principles. The error was corrected in our 2005 annual consolidated financial statements. Our audit committee, in consultation with our management, evaluated the impact of this error on our previously issued annual and interim consolidated financial statements and concluded that, based on a SAB 99 analysis which included quantitative and qualitative factors, in light of the facts and circumstances, the effect of the error was not material to any prior period and that a restatement was not required. Accordingly, management believes that the financial statements included in this report fairly present in all material respects our financial condition, results of operations and cash flows for the periods presented.
We have taken appropriate steps during the first quarter of 2006 to remediate the identified material weakness by correcting the methodology used to calculate diluted shares outstanding, placing further controls around this process, and acquiring a third-party software product to automate this process, with the new product to be run in parallel with the existing system. While the remediation measures have improved the design effectiveness of our internal control over financial reporting, the newly-designed
controls have not operated for a sufficient period of time to demonstrate operating effectiveness. We will continue to test, monitor and assess our remediation activities to ensure that this material weakness is remediated as soon as practicable.
Changes in Internal Control over Financial Reporting
Management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, whether any changes in our internal control over financial reporting that occurred during our last fiscal quarter have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. No such changes occurred during our last fiscal quarter. However, based on the evaluation we conducted during the first quarter of 2006, management has implemented changes described above as a result of the material weakness identified. Management believes the measures that we have implemented to remediate the material weakness relating to the calculation of diluted shares outstanding have had a material impact on our internal control over financial reporting during the first quarter of 2006 and anticipates that these measures and other ongoing enhancements will continue to have a material impact on our internal control over financial reporting in future periods.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item is incorporated herein by reference to our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated herein by reference to our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
On October 2, 1998, the Company adopted the 1998 Stock Plan, under which incentive stock options, non-qualified stock options or stock rights, or any combination thereof may be granted to the Company’s employees. As of December 31, 2005, there are 8.0 million shares authorized under the Company’s Stock Option Plan.
The following table summarizes equity compensation plans as of December 31, 2005.
All additional information required by this item is incorporated herein by reference to our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated herein by reference to our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is incorporated herein by reference to our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(1) Incorporated herein by reference to the exhibits to the Company’s Registration Statement on Form S-1 (File No. 33-89049).
(2) Incorporated herein by reference to the exhibits to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003.
(3) Incorporated herein by reference to the exhibits to the Company’s Annual report on Form 10-K for the year ended December 31, 2004.
(4) Incorporated herein by reference to the exhibits to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005.
(5) Incorporated herein by reference to the exhibits to the Company’s Current Report on Form 8-K dated February 14, 2006.
* Indicates a management contract or compensatory plan or arrangement
(B) EXHIBITS.
The Company hereby files as part of this Form 10-K the exhibits listed on the Exhibit Index referenced in Item 15(A)(3) above. Exhibits can be inspected and copied at the public reference facilities maintained by the Commission, 100 F Street, N.E., Room 1580, Washington, D.C., 20549. In addition we are required to file electronic versions of these documents with the Commission through the Commission’s Electronic Data Gathering, Analysis and Retrieval (EDGAR) system. The Commission maintains a website at http://www.sec.gov that contains reports, proxy and information statements and other information regarding registrants that file electronically with the Commission.
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, in the city of Washington, District of Columbia, on the 12th day of April 2006.
Varsity Group Inc.
By:
/s/ Mark F. Thimmig
Mark F. Thimmig
Chief Executive Officer and President
POWER OF ATTORNEY AND SIGNATURES
We, the undersigned officers and directors of Varsity Group Inc., hereby severally constitute and appoint Eric J. Kuhn, our true and lawful attorney, with full power to him, to sign for us in our names in the capacities indicated below, amendments to this report, and generally to do all things in our names and on our behalf in such capacities to enable Varsity Group Inc. to comply with the provisions of the Securities Exchange Act of 1934, as amended, and all requirements of the Securities and Exchange Commission. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and
Stockholders of Varsity Group Inc.:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations and comprehensive income, of stockholders’ equity and of cash flows present fairly, in all material respects, the financial position of Varsity Group Inc. and its subsidiaries at December 31, 2005 and December 31, 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. 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 of these statements 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
McLean, Virginia
April 12, 2006
VARSITY GROUP INC.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
Years ended December 31, 2005, 2004 and 2003
(in thousands, except per share data)
See accompanying notes to consolidated financial statements.
VARSITY GROUP INC.
CONSOLIDATED BALANCE SHEETS
As of December 31, 2005 and 2004
(in thousands, except share data)
See accompanying notes to consolidated financial statements.
VARSITY GROUP INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
Years ended December 31, 2005, 2004 and 2003
(in thousands, except share data)
See accompanying notes to consolidated financial statements.
VARSITY GROUP INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 2005, 2004 and 2003
(in thousands)
See accompanying notes to consolidated financial statements.
VARSITY GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. DESCRIPTION OF BUSINESS
Varsity Group Inc. (the “Company”) is an Internet-based retailer of textbooks and educational materials targeting private middle and high schools, small colleges and distance and continuing education markets nationwide and most recently, through its wholly owned subsidiary, Campus Outfitters, a retailer of private elementary, middle and high school uniforms with physical retail locations in Indiana, Maryland, Michigan, North Carolina, New York, Ohio, Texas and Virginia.
Varsity Group Inc. was incorporated on December 16, 1997 and launched its website, www.varsitybooks.com, in August 1998, at which time the Company began generating revenues. The Company sells textbooks online through exclusive contractual relationships it forges with private middle and high schools, small colleges, distance, and continuing education institutions within its eduPartners program. Schools participating in the eduPartners program have partnered directly with the Company to outsource their traditional brick and mortar bookstore operations and sell textbooks and learning materials directly to parents and students via the VarsityBooks.com website.
On May 26, 2005, the Company acquired substantially all of the assets of privately-held Campus Outfitters, L.L.C. (“Campus Outfitters”), a leading retailer of private elementary, middle and high school uniforms based in College Park, Maryland, with additional retail locations in Rockville, MD; Fairfax, VA; Raleigh, NC; Buffalo, NY; Southfield, MI; Richardson, TX; Cincinnati, OH; and Indianapolis, IN. Similar to the eduPartners model, Campus Outfitters forges exclusive relationships with schools to provide school logo embroidered uniforms to students and families directly via both physical retail locations and online via its website at www.campusoutfitters.com.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated.
USE OF ESTIMATES
The preparation of consolidated financial statements in conformity with accounting principles generally accepted within the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
FAIR VALUE INFORMATION
The carrying amounts of current assets and current liabilities approximate fair value because of the short maturity of these items.
CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
Cash, cash equivalents and short-term investments are comprised of amounts in operating accounts, money market investments and other short-term, highly liquid investments. Each is recorded at cost, which approximates market value. The Company’s policy is to record investment securities with original remaining securities of three months or less as cash equivalents. Investment securities with original or remaining maturities of more than three months but less than one year are considered short-term investments. The Company designates its short-term investments as available for sale with unrealized gains or losses reported as a separate component of stockholders’ equity. The fair value of the Company’s investments was determined based on quoted market prices at the reporting date for those instruments. The balance at December 31, 2005 was comprised of $2.7 million in operating accounts, $0.1 million in money market investments and $3.3 million in short term investments in auction rate marketable securities. The balance at December 31, 2004 was comprised of $4.1 million in operating accounts, $0.8 million in money market investments and $7.0 million in short term investments in auction rate marketable securities.
LONG-TERM INVESTMENTS
Long-term investments are designated as available-for-sale and, accordingly, are presented at fair value with unrealized gains and losses reported as a component of stockholders’ equity on the Company’s balance sheets. On December 31,
2005, long-term investments included fixed rate obligations of corporations and governments and agencies. The balance of long-term investments at December 31, 2005 and 2004 was $6.4 million and $7.0 million, respectively. As of December 31, 2005, all of the Company’s long-term investments had maturity dates of less than three years.
CONCENTRATIONS OF CREDIT RISK
Accounts receivable consists primarily of amounts due from the Company’s member institutions. The Company monitors its accounts receivable balances to assess any collectability issues. The Company recorded an allowance for potentially uncollectible receivables of $80,000 and $15,000 at December 31, 2005 and 2004, respectively. The allowance for potentially uncollectible receivables is included as a reduction of accounts receivable in the accompanying consolidated balance sheet. Bad debt expense for the years ended December 31, 2005, 2004 and 2003 was $109,000, $151,000 and $(11,800), respectively. The negative bad debt expense in fiscal 2003 was attributable to the recovery of a previously written-off receivable.
RELIANCE ON SUPPLIERS
The Company primarily relies on a single supplier as its primary provider of textbooks, fulfillment and shipping services. While the Company believes it could obtain these services from other qualified suppliers on similar terms and conditions, a disruption in the supply of these services by the current supplier could materially harm the business. (See Note 3).
The Company relies on four suppliers to provide approximately 60% of its uniforms. While the Company uses approximately 100 suppliers to provide all of its needs, a disruption in the supply of this inventory from any one of the Company’s top four suppliers could materially harm the business.
Substantially all of the Company’s computer and communications hardware and software systems are located at a single facility that is owned, maintained and serviced by a third party. Any damage, failure or delay that causes interruptions in the Company’s systems operations could materially harm the Company’s business.
PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost and are depreciated using the straight-line method over the estimated useful lives of the assets or the lease term, whichever is shorter. Furniture and fixtures, machinery, and computer equipment are depreciated over useful lives generally ranging from three to ten years. Software is depreciated over useful lives of 18 months. Leasehold improvements are amortized over the shorter of the lease term or the useful life of the improvements. Repairs and maintenance costs are expensed as incurred
SOFTWARE DEVELOPED FOR INTERNAL USE
The Company capitalizes certain costs to develop or obtain internal use software in accordance with American Institute of Certified Public Accountants (“AICPA”) Statement of Position No. 98-1 (“SOP 98-1”), “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” These capitalized costs are amortized on a straight-line basis over a period of one to five years after completion or acquisition of the software. Software developed for internal use is included in intangible assets in the Company’s Consolidated Balance Sheets as of December 31, 2005 and 2004.
LONG-LIVED ASSETS
The Company’s policy is to review its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” The Company recognizes an impairment loss when the sum of expected undiscounted net future cash flows is less than the carrying amount of the assets. The amount of the impairment is measured as the difference between the asset’s estimated fair value and its book value. Fair market value is determined primarily using the projected future cash flows discounted at a rate commensurate with the risk involved.
REVENUE RECOGNITION
The Company recognizes revenue from textbook and uniform sales, net of any discounts and coupons, when its customers receive the products. The Company takes title to new textbooks sold online via its eduPartners program upon transfer to the shipper and assumes the risks and rewards of ownership including the risk of loss for collection. The Company takes title to its uniform and textbook inventory held at its retail locations at the time of purchase from the supplier, publisher or buyback customer and places them in inventory as available for sale at that time. The Company does not function as an agent or broker for its supplier (see Note 3). Outbound shipping charges are included in net sales. The Company provides allowances for sales returns, promotional discounts and coupons based on historical experience in the period of the sale. Through May 2005, the Company’s revenues consisted primarily of sales of
textbooks. After its acquisition of Campus Outfitters on May 2005, the Company’s revenues have consisted of sales of textbooks and uniforms.
SALES AND MARKETING
Payments to the Company’s partnership program schools are accrued as the related revenue is earned. Such amounts are included as a component of sales and marketing expense in the accompanying consolidated statements of operations. The Company recognized an expense of approximately $1.2 million, $0.8 million and $0.6 million for payments earned by its partnership program schools for the years ended December 31, 2005, 2004 and 2003, respectively.
The Company’s agreement with B&T provides for assignment of separate values to the separate services provided by B&T: supply of books, shipping and other services, including website content and customer database management. Such assignment is based on the relative fair value of each element as determined by B&T. The Company has included in “cost of product” in its statement of operations the cost of purchased books from B&T, the cost of shipping charges from B&T in “shipping”, and the cost of other services including website content and customer database management charged by B&T in the “sales and marketing” section of its statement of operations. Expenses associated with these agreements recorded in the “sales and marketing” section of its statement of operations totaled $2.1 million, $2.1 million and $1.4 million for the years ended December 31, 2005, 2004 and 2003, respectively.
INTANGIBLE ASSETS AND GOODWILL
Intangible assets include goodwill, customer related assets, non-compete agreements and trademarks. Goodwill, which is equal to the excess of cost over the fair value of acquired net assets, has been recorded in conjunction with the acquisition of Campus Outfitters in May 2005. Customer related assets are amortized on a straight-line basis over ten years. Non-compete agreements and trademarks are amortized on a straight-line basis over three years. In accordance with Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets” (“SFAS 142”), the Company does not amortize goodwill.
STOCK-BASED COMPENSATION
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS 148”). SFAS 148 amends SFAS 123, “Accounting for Stock-Based Compensation,” 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 amends the disclosure requirements of SFAS 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.
The Company has elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations, in accounting for its employee stock options and complies with the disclosure requirements of SFAS No. 123, Accounting for Stock-Based Compensation. APB No. 25 provides that the compensation expense relative to the Company’s employee stock options is measured based on the intrinsic value of the stock option. SFAS No. 123 requires companies that continue to follow APB No. 25 to provide a pro forma disclosure of the impact of applying the fair value method of SFAS No. 123. Had compensation cost for the Company’s stock-based compensation plans been determined consistent with SFAS No. 123, the Company’s net income and income per share would have been as follows (in thousands, except per share data):
The weighted-average fair value of options granted during the years ended December 31, 2005, 2004 and 2003 was approximately $2.37, $3.20 and $1.51 respectively, based on the Black-Scholes option pricing model. The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model. The following weighted-average assumptions used for grants during the fiscal years ended:
•
2005: dividend yield 0.0%; expected volatility 50%; risk-free interest rate 3.63%; expected term 2 to 6 years;
•
2004: dividend yield 0.0%; expected volatility 90%; risk-free interest rate 3.60%; expected term 2 to 6 years; and
•
2003: dividend yield 0.0%; expected volatility 90%; risk-free interest rate 3.60%; expected term 2 to 6 years.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which replaces SFAS No. 123 and supercedes APB Opinion No. 25 and requires all share-based payments to employees and directors, including grants of employee and director stock options, to be recognized in the financial statements based on their fair values. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. The Company is required to adopt SFAS 123(R) in the first quarter of 2006.
SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods:
1. A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123(R) that remain unvested on the effective date; and
2. A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS 123 for purposes of pro-forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption.
The Company plans to use the modified prospective method. The remaining compensation cost related to previous grants that will be recognized in the financial statements pursuant to the modified prospective method in future fiscal years will be approximately $0.2 million.
Through December 31, 2005, the Company accounted for share-based payments to employees and directors using the intrinsic value method. Under this method, the Company generally did not recognize any compensation related to stock option grants issued under its equity compensation plans. Accordingly, the adoption of SFAS 123(R)’s fair value method could potentially have a significant impact on the Company’s results of operations, although it will have no impact on the Company’s overall financial position. The impact of adoption of SFAS 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted SFAS 123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net income (loss) and earnings per share above.
On December 19, 2005, the Board of Directors, upon recommendation of the Compensation and Stock Option Committee, approved the immediate vesting of all unvested stock options with an exercise price greater than $4.10 per share held by certain current employees, including executive officers and members of the board of directors. The Board made the decision to immediately vest these options in part due to the issuance of SFAS 123(R). By vesting all previously unvested options, the stock-based compensation expense under SFAS 123 will only be reflected in the Company’s footnote disclosures.
COMPREHENSIVE INCOME
The Company follows the provisions of SFAS No. 130, “Reporting Comprehensive Income” (SFAS No. 130). SFAS No. 130 requires disclosure of all components of comprehensive (loss) income on an annual and interim basis.
INCOME TAXES
The Company accounts for income taxes by utilizing the asset and liability method. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts, based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect the taxable income. Valuation allowances are established when necessary to reduce net deferred tax assets to the amount expected to be realized. (See Note 15.)
SEGMENT REPORTING
The Company’s operations are aggregated into two business segments across domestic and international markets: textbook trade and uniform trade. International sales are not material. Substantially all of the Company’s operating results and all of its identifiable assets are in the United States.
RECENT ACCOUNTING STANDARDS
In November of 2004, FASB issued Statement No 151, “Inventory Costs”, an amendment of Accounting Research Bulletin No. 43, Chapter 4 (“SFAS 151”). The amendments made by SFAS 151 clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The FASB’s goal is to promote convergence of accounting standards internationally by adopting language similar to that used in the International Accounting Standard 2, Inventories adopted by the International Accounting Standards Board (IASB). The Boards noted that the wording of the original standards were similar but were concerned that the differences would lead to inconsistent application of those similar requirements. The guidance is effective for inventory costs incurred during the Company’s year beginning January 1, 2006. The Company does not believe that the adoption of the new standard will have a material impact on its financial position.
In December 2004, the FASB issued SFAS 123(R). See Note 2: “Stock-Based Compensation.”
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”). Under SFAS 154, entities will be required to report a change in accounting principle through retrospective application of the new accounting principle to all prior periods, unless impracticable to do so. In addition, errors in the financial statements of a prior period discovered subsequent to their issuance shall be reported as a prior period adjustment by restating the prior period financial statements. This standard will be effective for accounting changes and corrections of errors made, if any, in fiscal years beginning after December 15, 2005. Management does not believe the adoption of this standard will have a material impact on the Company’s financial position in 2006.
In October 2005, the FASB issued FASB Staff Position FAS 123 (R)-2, “Practical Accommodation to the Application of Grant Date as Defined in FASB Statement No. 123(R)” (“FSP 123R-2”). FSP 123R-2 requires companies to estimate the fair value of share based payment awards when the award has been granted. One of the criteria for determining that an award has been granted is that the employer and its employees have a mutual understanding of the key terms and conditions of the award. Under FSP 123 R-2, a mutual understanding is assumed to exist on the date the award is approved by the Board of Directors and the key terms and conditions of the award are expected to be communicated to the individual within a relatively short time period from the date of approval. The Company is required to adopt FSP 123R-2 in the first quarter of 2006.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform the current year presentation. These changes have no impact on previously reported results of operations or stockholders’ equity.
3. TRANSACTIONS WITH BAKER & TAYLOR
Baker & Taylor (“B&T”) has provided the Company’s order fulfillment and drop shipment services since its inception. The Company has a series of agreements relating to the operating and financial terms of its relationship, which were renewed in July 2005 and are now scheduled to expire in June 2008.
Under these agreements, the Company agrees to provide B&T with written demand forecasts for each upcoming semester and to use B&T as its principal supplier of textbooks and drop-ship and fulfillment services for textbooks and educational materials. The Company pays fees and expenses related to the services B&T provides and purchases products from B&T at a discount to the suggested price. In return, B&T agrees not to provide drop-ship services to any person or entity that has as its principal business activity the goal of establishing exclusive relationships with educational institutions for the purpose of selling textbooks via the Internet, unless the retailer was an existing customer of B&T on or prior to June 10, 1998, the date the Company initially contracted with B&T. The Company’s agreements with Baker & Taylor provide it access to, and use of, an electronic set of data elements from B&T’s title file database that contains bibliographic records. In addition, under these agreements, B&T provides the Company with promotional, customer service, and database management services
In July 2003, B&T was purchased in a transaction sponsored by a third party private equity firm. Prior to this transaction B&T was considered a related party due to common ownership interests held by The Carlyle Group as the
principal owner of B&T and as significant shareholder of Varsity Group. Effective with the sale of B&T in July 2003, the Company no longer considers B&T to be a related party.
As of December 31, 2005 and 2004, B&T owed the Company approximately $4.1 million and $1.1 million, respectively, related to certain rebates that the Company had earned during those years. Balances owed to the Company are included in other current assets in our Consolidated Balance Sheets as of December 31, 2005 and 2004.
4. ACQUISITION
On May 26, 2005, the Company acquired substantially all of the assets of privately-held Campus Outfitters, LLC, for cash of approximately $3.1 million and 123,967 shares of common stock with a fair value of approximately $0.7 million, for total consideration paid of approximately $3.8 million, plus the assumption of certain liabilities. The Company may be required to make additional contingent payments if the common stock recipients do not sell, pledge, or in any way transfer the common stock before the two year anniversary of the acquisition close date and the value of the Company’s common stock is not equal to or greater than the per share purchase price on the two year anniversary date. The additional contingent payments, if any, would be payable in cash or shares of the Company’s common stock.
Campus Outfitters is based in College Park, MD, with additional retail locations in Rockville, MD; Fairfax, VA; Raleigh, NC; Buffalo, NY; Southfield, MI; Richardson, TX; Cincinnati, OH; and Indianapolis, IN and is a leading provider of uniform needs for private schools. The Campus Outfitters acquisition allows the Company to offer a comprehensive solution to provide textbooks, uniforms and school supplies to private K-12 school communities and allows the Company to leverage relationships with schools partnered with Varsity Books and Campus Outfitters to cross-promote the other product lines.
The results of operations for Campus Outfitters have been included in the Company’s operations since the acquisition date. The purchase price has been allocated to the assets acquired and liabilities assumed based on management’s estimates of their applicable fair value. Management estimates of the fair value of identifiable intangible assets acquired was based on discounted cash flow techniques that included significant estimates about future performance. The initial weighted average amortization period for all intangible assets acquired in this transaction that are subject to amortization is 7.25 years. The following summarizes the fair values of the assets acquired and liabilities assumed at the date of acquisition (in thousands):
The results of operations for Campus Outfitters have been included in the Company’s operations since the acquisition date. Unaudited pro forma results of operations for the years ended December 31, 2005 and 2004 are included below. Such pro forma information assumes that the acquisition had occurred as of January 1, 2004. This summary is not necessarily indicative of what the Company’s results of operations would have been had the Company and Campus Outfitters been a consolidated entity during such periods, this information is unaudited and does not purport to represent results of operations for any future periods (in thousands, except per share data):
5. OTHER CURRENT ASSETS
The following is a summary of other current assets as of December 31, 2005 and 2004 (in thousands):
•
Rebates due from B&T are amounts due to the Company for meeting certain thresholds during the year;
•
Returns-in-transit consists of new textbooks that the Company returned to publishers for credit during the fourth quarter of fiscal 2005 that had not yet been processed by the publishers as of December 31, 2005.
6. CASH, CASH EQUIVALENTS AND INVESTMENTS
The following is a summary of our cash, cash equivalents and investments as of December 31, 2005 and 2004 (in thousands):
7. INVENTORIES
Inventories, consisting of products available for sale, are valued at the lower of cost or market value and are accounted for principally using the FIFO method. The Company’s inventory balance as of December 31, 2005 and December 31, 2004 consists of (in thousands):
The components of inventory are as follows:
•
New textbooks consist of new book inventory held at Baker & Taylor (“B&T”), our fulfillment partner, acquired by B&T in support of our eduPartners program for which they generally do not enjoy standard
return privileges with the publisher. New textbooks also include inventory held at Campus Outfitters retail locations and new textbooks held at other locations; and
•
Used textbooks consist of used textbooks held at B&T, Campus Outfitters retail locations, or other locations;
•
Uniforms and apparel consists of school uniform related inventory held at our Campus Outfitters warehouses or retail locations.
Under the Company’s agreement with B&T in which B&T provides most of the Company’s order fulfillment and drop shipment services, B&T generally only assumes ownership of new textbooks that they are able to return to publishers for credit, which historically has approximated 90% of all new textbook inventories. B&T does not assume ownership of the used products it processes for the Company and per the agreement with B&T, the Company purchases from B&T at cost new textbooks that B&T procured in support of our eduPartners program and cannot return for publisher credit at the conclusion of each selling season. This inventory has typically been held by B&T for fulfillment in subsequent periods. On a quarterly basis, the Company assess for write down its inventory for estimated excess and obsolete or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions on a quarterly basis.
8. PROPERTY & EQUIPMENT
Property and equipment consist of the following at December 31, (in thousands):
Depreciation expense was approximately $0.2 million, $0.1 million and $0.1 million for the years ended December 31, 2005, 2004 and 2003, respectively.
9. SOFTWARE DEVELOPED FOR INTERNAL USE
The Company capitalized software developed for internal use costs of $0.7 million and $0.8 million for fiscal 2005 and 2004, respectively. The Company recorded related amortization of $0.2 million and $0.1 million for fiscal 2005 and 2004, respectively, in accordance with SOP 98-1. Costs associated with software developed for internal use are capitalized as they are incurred and are amortized on a straight-line basis over a period of one to five years after completion or acquisition of the software.
10. INTANGIBLE ASSETS AND GOODWILL
Intangible assets as of December 31, 2005, based on the purchase price allocation of the May 2005 Campus Outfitters acquisition were as follows (in thousands):
The changes in the amount of carrying value of goodwill in the year ended December 31, 2005 were as follows (amounts in thousands):
Amortization expense related to the Campus Outfitters intangible assets was approximately $0.1 million in fiscal 2005. Estimated aggregate future amortization expense for intangible assets remaining as of December 31, 2005 is as follows: (amounts in thousands):
11. COMMITMENTS AND CONTINGENCIES
LEASES
The Company’s headquarters is located at 1850 M Street, Suite 1150, Washington, D.C. The Company currently occupies approximately 69,000 square feet of office and warehouse space pursuant to leases that are month-to-month or are scheduled to expire between May 2006 and May 2015.
Rent expense under operating leases was approximately $0.7 million, $0.2 million and $0.1 million for the years ended December 31, 2005, 2004 and 2003, respectively. The remaining lease payments associated with the Company’s current operating leases are as follows:
(1) Includes payments made through April 2006 for month-to-month leases.
(2) On March 31, 2006, the Company entered into a four-year lease agreement for a new headquarters facility at 1300 19th Street, Suite 800, Washington, DC for approximately 16,000 square feet. This lease will replace the Company’s existing headquarters facilities at 1850 M Street, Washington. DC, which expires in May 2006. The Company moved into its new headquarters space during its second quarter of fiscal 2006. The Company’s expected total cash obligation of approximately $2.5 million over the full four-year term of the lease is included in the table above. See Note 19.
LEGAL PROCEEDINGS
The Company is party to various legal proceedings and claims incidental to our business. Management does not believe that the resolution of any such matters that are pending as of the date of this report will have a material adverse effect on the results of operations or financial condition of our Company.
12. STOCKHOLDERS’ EQUITY
AUTHORIZED CAPITAL
At December 31, 2005, the Company was authorized to issue 20,000,000 shares of preferred stock, $.0001 par value per share, and 60,000,000 shares of common stock, $.0001 par value per share.
WARRANTS
During fiscal 1998 and fiscal 1999, in connection with the issuance of convertible promissory notes, the Company issued warrants to purchase 160,707 shares of the Company’s common stock. No warrants associated with these grants were exercised prior to fiscal 2003. During fiscal 2003, warrants to purchase 82,547 shares of the Company’s common stock were exercised. During fiscal 2005, warrants to purchase 10,145 shares of the Company’s common stock were exercised.
During fiscal 1998 and fiscal 1999, the Company issued warrants to B&T, its supplier of textbooks, to purchase up to 219,643 shares of common stock at exercise prices of $2.33, $0.20 and $0.22 per share. No warrants associated with these grants were exercised prior to fiscal 2003. During fiscal 2003, warrants to purchase 52,251 shares of the Company’s common stock were exercised and 104,892 warrants were either cancelled or expired without being exercised. The 62,500 warrants that remained outstanding as of December 31, 2003 were exercised in February 2004.
During fiscal 2000, in connection with a line of credit agreement that has since expired, the Company issued warrants to purchase 37,500 shares of its common stock at an exercise price of $10.00 per share. The 37,500 warrants outstanding as of December 31, 2004 expired in fiscal 2005.
During fiscal 2000, the Company issued warrants to a third party to purchase up to 50,000 shares of common stock at an exercise price of $1.06 per share in return for certain advisory and consulting services. As of December 31, 2005, warrants to purchase up to 25,000 shares of the Company’s common stock were exercisable at an exercise price of $1.06 per share.
TREASURY SHARES
In November 2004, the Company repurchased 83,334 shares of the Company’s common stock from an officer of the Company for approximately $0.5 million. The purchase price of the shares was $6.00 per share, representing a five percent discount from the 30-day trailing average prior to the repurchase date. In October 2003, the Company repurchased 175,000 shares of the Company’s common stock from two officers of the Company for approximately $0.7 million. The purchase price of the shares was $3.765 per share, representing a five percent discount from the 30-day trailing average prior to the repurchase date. These transactions had no effect on the Company’s results of operations. As of December 31, 2005, the Company’s cumulative repurchases totaled 1,215,397 shares for approximately $1.7 million in cash.
13. STOCK-BASED COMPENSATION
On October 2, 1998, the Company adopted the 1998 Stock Plan, under which incentive stock options, non-qualified stock options or stock rights, or any combination thereof may be granted to the Company’s employees. The Board of Directors, or a Committee appointed by the Board, administers the Plan and determines the individuals to whom options will be granted, the number of options granted, the exercise price and vesting schedule. Options are exercisable at prices established at the date of grant and have a term of ten years and vesting periods between 12 and 60 months. Vested options held at the date of termination may be exercised within three months. The Board of Directors may terminate the Plan at anytime. On December 19, 2005, the Board of Directors, upon recommendation of the Compensation and Stock Option Committee, approved the acceleration of the vesting of all unvested stock options greater than $4.10 per share, which was the fair value of the Company’s stock at that date, held by certain current employees, including executive officers and members of the Board of Directors. See Note 2.
Stock option activity was as follows (amounts in thousands, except per share data):
As of December 31, 2005 the Company has reserved an additional 798,048 shares of its common stock for future option grants. As of December 31, 2005, there are 8.0 million shares authorized under the Company’s Stock Option Plan.
The following table summarizes information about options at December 31, 2005.
As of December 31, 2005, 2004 and 2003, the weighted average remaining contractual life of the options was 7.2, 7.8 and 7.8 years, respectively.
No options were granted during the year ended December 31, 2005, 2004 or 2003 that were deemed to be compensatory and, therefore, no deferred compensation was recorded.
Non-cash compensation expense related to the granting of employee options, warrants and the sale of restricted stock based upon the intrinsic value method was $0, $40,000 and $0.2 million during the years ended December 31, 2005, 2004 and 2003, respectively. The expense amounts recorded represent the difference between the exercise price and the deemed fair value (the fair value per share was derived by reference to the preferred stock values since inception with ratable increases between preferred stock issuance dates prior to the initial public offering and the NASDAQ or OTC Bulletin Board stock price on the date of issuance following the initial public offering) of the underlying common stock on the date of grant.
14. EARNINGS PER SHARE
Financial Accounting Standards Board Statement No. 128, “Earnings per Share” (“SFAS 128”) promulgates accounting standards for the computation and manner of presentation of the Company’s earnings per share data. Under SFAS 128, the Company is required to present basic and diluted earnings per share. Basic earnings per share is computed by dividing net income applicable to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects dilution that would occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that shared in the earnings of the Company. The 2005, 2004, and 2003, diluted earnings per share amounts exclude the effects of 1,844,000, 955,000, and 579,000 stock options outstanding, respectively, as their inclusion would be antidilutive.
The following table sets forth the computation of basic and diluted income per share (in thousands, except per share data):
15. INCOME TAXES
The income tax (benefit) expense for 2005, 2004 and 2003 consists of the following:
The income tax benefit recognized differs from the expense at the maximum statutory Federal tax rate as follows:
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities are as follows at December 31 (in thousands):
At December 31, 2005 and 2004, the Company had net operating loss carryforwards of approximately $57.3 million and $60.3 million, respectively, related to federal and state jurisdictions. These net operating loss carryforwards will begin to expire at various times beginning in 2018. For federal and state tax purposes, a portion of the Company’s net operating loss may be subject to certain limitations on annual utilization in case of changes in ownership, as defined by federal and state tax laws.
At December 31, 2005, the Company had Alternative Minimum Tax (“AMT”) credit carryforwards of approximately $0.1 million. These credits do not expire and will be available to reduce future Federal income tax liabilities.
The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109 (“SFAS 109,”) “Accounting for Income Taxes.” Under SFAS No. 109, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. In determining the need for a valuation allowance, our management reviews both positive and negative evidence pursuant to the requirements of SFAS No. 109, including current and historical results of operations, the annual limitation on utilization of net operating loss carry forwards pursuant to Internal Revenue Code Section 382, future income projections and the overall prospects of our business. Based upon management’s assessment of all available evidence, including our cumulative net income for recent fiscal years, estimates of current and future profitability and the overall prospects of our business, management concluded in our second and third quarters of 2004 and again in our third quarter of fiscal 2005 that it was more likely than not that a portion of the recorded deferred tax benefits would be realized. In 2005, the Company released $10.0 million of the valuation allowance. The Company will continue to monitor all available evidence and reassess the potential realization of our deferred tax assets. If the Company continues to meet its financial projections and improve upon its results of operations, it is reasonably possible that the Company may release all, or a portion, of the remaining valuation allowance in the future. Such releases, thereafter, if relating to certain option deductions, increase additional-paid-in-capital would result in recording a tax benefit that would increase net income in the period the allowance is released. Approximately $1.9 million of the valuation allowance relates to net operating losses resulting from stock option windfall benefits, e.g. disqualifying dispositions. Reductions in the valuation allowance for those assets will result in an increase to additional paid-in capital after the valuation allowance related to all other deferred tax assets amounts have been reduced.
16. BUSINESS SEGMENTS.
Prior to the Company’s acquisition of Campus Outfitters in May 2005 (see Note 4), the Company was primarily an internet retailer of textbooks and educational materials targeting private middle and high schools, small colleges and distance and continuing education markets. The Company’s chief operating decision maker reviewed financial information presented on a consolidated basis. Accordingly, the Company considered itself to be in a single industry segment. In May 2005, the Company added a second product line with its acquisition of Campus Outfitters, a leading provider of uniform needs to private schools. Accordingly, beginning in its third quarter of fiscal 2005, the Company’s operations were aggregated into two reportable business segments: textbook trade and uniform trade. International sales are not material. Substantially all of the Company’s operating results and all of its identifiable assets are in the United States.
The business segments reported below are the segments of the Company for which discrete financial information was available and for which the Company’s chief operating decision maker evaluated gross margins in fiscal 2005:
17. RELATED PARTY TRANSACTION.
Connected with the acquisition of Campus Outfitters (see Note 4), the Company assumed eleven leases to Campus Outfitters retail stores, including the lease to the Campus Outfitters 16,800 square foot corporate headquarters building in College Park, MD. Campus Outfitters headquarters building is owned by 5112 Berwyn LLC, a Maryland limited liability company whose controlling shareholders are Mr. Adam Hanin, the founder of Campus Outfitters and current Executive Vice President of Sales for Varsity Group, and Mr. Elliott Hanin, who was employed by Campus Outfitters prior to the acquisition and is a current employee of Varsity Group. Under terms of the lease, the Company is obligated to pay 5112 Berwyn LLC $18,000 a month through May 2015. The Company’s total related party payments in fiscal 2005 were approximately $0.1 million.
18. SELECTED QUARTERLY FINANCIAL DATA (Unaudited)
The Company experiences significant seasonality in its results of operations. Consistent with the Company’s focus on the expansion of its eduPartners program and its current concentration of private middle and high school institutions, since the year ended December 31, 2000, the Company’s peak selling period for textbooks has been the July/August/September back-to-school season. Historically, Campus Outfitters has experienced the same seasonality in its results of operations prior to our acquisition on May 26, 2005. Consistent with its current concentration of private elementary, middle and high schools, Campus Outfitters peak selling season has been the July/August/September back-to-school season. During fiscal 2005 and 2004, approximately 86% and 85% of the Company’s revenues, respectively, were recognized in this period.
In addition, during the third quarter of fiscal 2005 and during the second and third quarters of fiscal 2004, the Company released $10.0 million, $1.0 million and $4.0 million, respectively, of its deferred tax asset valuation allowance when it deemed it was more likely than not that a portion of the recorded deferred tax benefits would be realized. See Note 15.
The following table presents summarized quarterly financial data (in thousands, except per share data):
19. SUBSEQUENT EVENTS
On February 15, 2006, the Company announced the hiring of Mark F. Thimmig as President and Chief Executive Officer of Varsity Group. Mr. Thimmig replaces Eric J. Kuhn, who will remain as the Company’s Chairman of the Board.
On March 28, 2006, the Company completed an asset purchase with White Hat on Campus, LLC, and Dr. Thomas Probert to acquire substantially all of the assets which comprise a content and payment acquisition system and related software business that connects learning developers and distributors through a portal model which is presently conducted at www.lydialearn.com. Total purchase price was approximately $0.4 million.
On March 31, 2006, the Company entered into a four-year lease agreement for a new headquarters facility at 1300 19th Street, Suite 800, Washington, D.C. for approximately 16,000 square feet. This lease will replace the Company’s existing headquarters facilities at 1850 M Street, Washington. DC, which expires in May 2006. The Company moved into its new headquarters space during its second quarter of fiscal 2006.