ITEM 1. BUSINESS
General
Moto Photo, Inc. (together with its subsidiaries, "the Company") is engaged in the franchising and ownership of stores offering one-hour photo processing services, portrait, and related imaging services and merchandise under the trade names and service marks of `MOTOPHOTO'', "ONE HOUR MOTOPHOTO", and "ONE HOUR MOTOPHOTO & PORTRAIT STUDIO.''
The Company was incorporated as an Oklahoma corporation on July 29, 1981 and was reincorporated under Delaware law in 1983.
Development of the System in 1997
During 1997, the Company granted nineteen new franchises and converted three independent stores to franchises, while twenty-one franchises were canceled or terminated, for a net increase of one franchise in the United States.
The Company's international franchises decreased by five. The Company's master licensor for the province of Ontario, Canada, Canadian Industrial Services, Inc., granted one new franchise, while six franchises were canceled or terminated. The Company's master licensor for Norway, Scan-Franchise, A/S, Ltd., neither granted nor terminated any new franchises during 1997. In 1997, all foreign source revenues represented less than 1% of total revenues. 1997 was a year of consolidation for the System. The Company terminated a number of underperforming franchises and franchises failing to meet System standards. Although this means that the number of franchises decreased, the Company believes these terminations will strengthen the System overall, as retail sales of the System increased to $140,000,000 in 1997 from $136,000,000 in 1996. To take advantage of the synergy and advertising power of groups of stores, the Company concentrated its efforts on increasing the number of franchises in target markets which already have a number of MotoPhoto stores.
During 1997, the Company opened no new company stores. In accordance with its decision in fourth quarter 1995 to keep only a core group of approximately 25 company stores to serve as training sites and as testing and research sites for products, services, and systems, the Company closed two stores and sold six others as franchises during 1997.
Summary of Store Development
Set forth below is a summary of the store development of the Company in the United States and abroad during 1996 and 1997:
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
Through the granting of franchises, conversion of independent stores, and acquisitions, Moto Photo, Inc. and its subsidiaries (`the Company'') have developed a system of 433 operational stores at December 31, 1997 compared to 444 at December 31, 1996.
Systemwide sales increased to approximately $140,000,000 in 1997 from $136,000,000 in 1996. The Company plans to grow through granting new franchises, conversion of independent stores to franchise stores, sale of selected Company stores as franchises (`refranchising''), opening Company stores in core markets and selective acquisitions, as well as increasing the average sales per store older than one year from $380,000 to $550,000. By 2002, the Company plans to have a 600 store system with systemwide sales in excess of $300,000,000.
The Company operates primarily in the specialty retail channel of the photo processing industry (see `Item 1. Business-Competition'' on page 8). There is a consolidation of specialty retail outlets occurring and the Company estimates that the four largest chains, of which the Company is one, have approximately 35-40% of the specialty retail photo processing market. The Company estimates its share at approximately 10% of the stand-alone one hour processing market.
The Company believes it is well-positioned to be one of the major chains in the market as the consolidation continues because of its unique advantage of being the only significant franchisor in the industry. In a business where customer service and satisfaction are critical success factors, the Company believes that franchisees generally provide a higher level of service and customer satisfaction than Company stores. Furthermore, the Company believes its product offerings are different from those of many of its competitors, thereby giving the Company a further advantage.
The more system stores in a given local market, the better the stores in that market will generally do. Therefore, continued growth in target markets is an important strategy for the Company's long-range growth.
The Company believes it operates a `recession resistant'' business; however, a growing economy is beneficial for demand for the Company's products and services. Favorable weather, particularly on weekends, is important to store results and, therefore, Company results.
Foreign currency transactions are not material to the Company because transactions with the Company's suppliers are in U.S. dollars and the majority of the key supplier's manufacturing is currently done domestically. However, costs of certain photoprocessing equipment could be influenced by exchange rates.
The Company's business as a whole is subject to seasonal fluctuations. The demand for photo processing services is lowest in the first quarter and highest in the fourth quarter of the year. Year 2000
The Company is implementing plans to address potential exposures to various systems caused by the approach of the Year 2000. Many of the Company's systems are already Year 2000 compliant, while other systems are being upgraded, and, in some cases, the Company is using this opportunity to implement more modern systems which are already Year 2000 compliant. The financial impact of these changes is not expected to have a material effect on the Company's consolidated financial position, results of operations or cash flow.
In January 1995 the Company redeemed 417,500 shares of $1.20 Cumulative Convertible Preferred Stock (`$1.20 Stock'') and satisfied a cumulative dividend arrearage of $2,004,000 in exchange for $2.00 in cash and five common shares for each share of $1.20 stock (`the Redemption''), resulting in a $835,000 cash payment and the issuance of 2,087,500 common shares. Concurrently, the Series E and Series F Preferred Shares were exchanged for $10,000,000 of cumulative non-voting Series G Preferred Stock (`Series G Stock'). The Redemption and the Series G transaction lowered the preferred dividend requirements and accordingly increased the net income, or decreased the net loss, per common share. (See Note G)
RESULTS OF OPERATION 1997 VS. 1996
In 1997 the Company recorded net income of $1,703,535, or $.18 per common share (basic and diluted), compared to net income of $1,073,873 or $.10 per common share (basic and diluted), in 1996. Company revenue decreased by $1.4 million or 3.3% in 1997 compared to 1996.
Company store sales declined by $1.6 million or 8.6% in 1997 compared to 1996. In 1997 the Company continued its plan to implement its concept through franchisees while retaining a targeted core group of approximately 23 Company stores. Six Company stores were sold to franchisees in 1997 and two others were closed. Company store sales and related cost of sales and operating expenses declined as a result of the decrease in the number of Company stores operated. Company comparable stores sales increased $230,000 or 1.7% in 1997. The Company anticipates a continued decline in Company store sales and related cost of sales and operating expenses as the number of Company stores decreases from the current 43 stores to the planned 23 stores thoughout 1998 and 1999. In addition, the Company plans to open approximately six Company stores in its core markets in 1998 and 1999.
Company store cost of sales and operating expenses increased by .5% of sales in 1997 compared to 1996 due to an increase in labor costs resulting from a more competitive job market.
Merchandise sales increased by $356,000, or 2%, in 1997 compared to 1996 as a result of an 8% increase in franchise comparable store sales being partially offset by lower prices on film due to spot market conditions and a net reduction of approximately 2% in the number of stores. The Company's strategy is to remain competitive in its pricing of products sold to franchisees and spot pricing conditions could alter these trends in the future.
Merchandise costs of sales and operating expenses in 1997 declined to 88% of merchandise sales from 90.5% in 1996 because of a 1.5% decrease in bad debt expense and a .5% decrease in paper costs as a result of the System using Fuji paper for the full year in 1997 as opposed to only a partial year in 1996.
Royalty revenue increased by $294,000 or 6% in 1997 compared to 1996, primarily due to an 8% increase in comparable franchise store sales offset by a net reduction of approximately 2% in the number of stores.
The Company anticipates continued growth in royalty revenues and merchandise sales as a result of the refranchising of Company stores, continued increases in comparable franchise stores sales, the number of new franchise stores, and continuing improvement in the quality of the average franchisee. In 1997 franchise fees were 42% lower than in 1996, reflecting the opening of 14 domestic stores in 1997 compared to 22 stores in 1996. Of the stores opened in 1997, 11 were either conversions or added stores by existing franchisees, both of which carry lower fees. This mix accounted for the further reduction of 1997 franchise fee revenue as compared to 1996. In the first quarter of 1998, the Company began offering a new franchising program which requires a lower initial investment and allows the franchisee to pay for the store investment as a percentage of sales rather than a fixed monthly payment. The Company believes that this new program, named MotoPhoto QuickStart SM., will increase the number of franchises sold, to 25 - 35 stores in 1998 and to 60 - 70 in 1999. (See `Item 1 -- Business)
The Company refranchised six stores in 1997 at a loss of $48,280 compared to five stores refranchised in 1996 at a gain of $78,051. In 1997, the loss on sales of stores is included in selling, general, and administrative expenses.
Telemarketing revenues increased by 35% in 1997 compared to 1996, due to sales to non-competitive businesses outside the franchise system. In 1998, the Company plans to rely less on sales to non-franchisees and, accordingly, telemarketing revenues are projected to decrease to approximately $700,000. Other income in 1996 was generated by the sale of a lease for a Company store.
Selling, general and administrative expenses were about the same in 1997 compared to 1996, although 1997 benefited from a reduction in bad debt expense associated with telemarketing. In 1997 certain increases in selling, general and administrative expenses were largely offset by lower selling expenses on lower franchise fee revenue and reduced bad debt expenses. Since the Company anticipates increased franchise fee revenues in 1998 there should be an increase in associated selling expense.
Advertising expenses decreased by $136,000 or 9% in 1997 compared to 1996 as the Company operated fewer stores in 1997 and implemented a planned decrease in advertising expenditures. In 1998 the Company plans to increase advertising associated with the introduction of MotoPhoto QuickStart SM. and increase other advertising expenditures by approximately 10%.
Depreciation and amortization expenses increased by $90,000 or 11.9% in 1997 compared to 1996 as a result of depreciation on additions to fixed assets in 1997. In 1998 depreciation and amortization expenses are planned to increase by approximately $150,000 as the Company continues to increase its capital expenditures primarily to add new services, such as 24 mm Advanced Photo System processing, digital kiosks, upgrading the design of certain Company stores, and opening new Company stores..
Interest expense remained relatively constant in 1997 compared to 1996 as the Company had slightly lower average borrowing in 1997 at slightly higher interest rates. Investment income, which is primarily interest income from notes receivable and temporary investments of cash, increased in 1997 due to increased notes receivable and improved liquidity. As the Company continues to sell Company stores and grow its franchise system, investment income will continue to grow.
Income tax expense in 1997 was $800,000, with an effective tax rate of 32% compared to $850,000, or a rate of 44% in 1996. The reduction is due primarily to the closing of two Company stores which created a deductible tax expense for assets previously written off for book purposes and for realization of other tax deductions for which no net deferred tax asset recognition was available to the Company. In 1998 the Company's tax rate should decrease again due to additional planned closings of Company stores which will create deductible tax expense for assets previously written off for book purposes.
RESULTS OF OPERATION 1996 VS 1995
In 1996 the Company recorded net income of $1,073,873, or $.10 per common share (basic and diluted), compared to net loss of $5.7 million, or a loss per common share of $.69 (basic and diluted), for 1995. The 1995 loss per common share also includes a positive adjustment of $673,219, or $.09 per share, resulting from the Redemption (See Note G). Company revenues increased $1 million, or 2.5%, in 1996 compared to 1995.
Company store sales in 1996 declined $1,300,000, or 6%, compared to 1995. Company comparable store sales increased $500,000, or 3%, and the differing number of Company stores operated in each period accounted for a $1.8 million decrease in Company store sales. Company store cost of sales and operating expenses decreased by 2.9% of sales or $544,000 in 1996 compared to 1995, as a result of lower management overhead costs (.5%) and higher margins on certain merchandise (1.2%). The balance of the cost and expense reduction was primarily due to spreading fixed costs over higher sales per store for the remaining Company stores.
In 1995 the Company determined that its concept is being more effectively implemented in the marketplace by franchisees rather than through Company stores. Accordingly, the Company decided to refranchise or close 39 of its Company stores while retaining a core group of approximately 23 company stores to be used for training and testing and research sites for products, services and systems. The Company recorded a restructuring charge of $5.8 million to write down the book value of these stores to their fair value less costs to sell in 1995 and $510,000 in 1996. (See Note L). As a result, a significant decline in Company store sales, cost of sales and operating expenses is anticipated once the closings and sales are completed.
In 1996 merchandise sales increased $2.1 million, or 13.6%, compared to 1995, primarily as a result of approximately a 7% increase in franchise comparable store sales, more franchise stores ordering paper and chemistry supplies from the Company (5%), and increased sales of film due to more targeted film marketing efforts (2%). Merchandise cost of sales and expenses increased to 90.5% of merchandise sales in 1996 compared to 89% in 1995, due to increased bad debt expenses of 2% of sales, partially offset by an increase in margins on color paper. In 1994, the Company's principal supplier of photographic paper, Fuji Photo Film USA, Inc. (`Fuji'') raised prices as a result of entering into an agreement with the United States Department of Commerce to resolve dumping claims brought by Eastman Kodak Company. This required the Company to make transitional purchasing arrangements with another supplier who, because of the relatively temporary contract, charged higher prices that the Company could not pass on. A Fuji production facility in the United States became operational in May 1996. The Company then returned to Fuji as its principal supplier at lower prices than the transitional purchasing arrangements.
Royalty revenue increased $419,000, or 9%, for 1996 compared to 1995, primarily due to a 7% increase in comparable franchise store sales and a generally improved quality of franchised store.
In 1996, franchise fees were significantly lower than in 1995, reflecting the opening of 22 stores in 1996 compared to 43 in 1995. Additionally, 11 of the 1996 openings were conversions of independent stores at a very low franchise fee. (See `Item 1. Business - Franchise Operations''). The decision to concentrate in core markets has led to reductions in selling, general and administrative costs that are greater than the decreased franchise fee revenue.
The Company refranchised five stores in 1996 at a gain of $78,051 versus two stores in 1995, at a gain of $46,266.
Sales of telemarketing services are expanding as a marketing method for portrait appointments and the Company began performing telemarketing services for non- competitive other businesses in 1996.
Selling, general, and administrative expenses fell $755,000, or 10%, for 1996 compared to 1995. For reasons noted above, the franchise development cost component of selling, general and administrative expenses was lower by $895,000.
Advertising expenses declined $261,000 because of lower Company store revenues, increased emphasis on telemarketing as a marketing method, and an $88,000 increase in franchise advertising consistent with the Company's 1996 development plan.
Depreciation and amortization expenses in 1996 were down $773,000 from 1995, primarily due to the restructuring and the revaluation of Company stores to fair value in anticipation of refranchising or closing 39 stores.
Interest expense increased $57,000, or 14%, for 1996 compared to 1995, primarily due to higher interest rates and increased borrowings.
The effective tax rate in 1996 was 44% compared to no income tax expense in 1995, reflecting profitable operations versus a large loss. In 1996 the effective state income tax rate was 13% due to non-recognition of net operating loss carrybacks by many states.
LIQUIDITY AND CAPITAL RESOURCES
In 1997, the Company's operating activities provided $169,000 of cash compared to $2.3 million in 1996. The primary reasons for the decrease were $2 million of increased payments of accounts payable resulting from paper stockpiling purchases of late 1994, and payment of another $1.1 million in accounts payable due to payments made in early 1997 that would have otherwise been made in 1996. These payments were partially offset by a reduction in net accounts receivable of $1.1 million, due primarily to more stringent credit practices with franchisees and a generally overall improved franchise store performance.
The Company's 1998 financial plan anticipates increased cash provided by operations primarily due to increased net income of at least 15% and cash provided by changes in accounts payable.
In 1996 cash provided by operating activities increased by $2.2 million from $100,000 in 1995 to $2.3 million in 1996. Contributing to this change were an increase in net income prior to restructuring charges of $1.5 million, a $900,000 increase in accounts payable and accrued expenses, and $400,000 less of an increase in net accounts receivable. These increases were offset by an $800,000 reduction in depreciation and amortization expenses.
In 1997 net cash provided by investing activities decreased approximately $300,000 to $558,000. In 1996 net cash provided by investing activities was $800,000 as compared to net cash utilized in investing activities in 1995 of over $1 million. Reduced purchases of property and equipment in 1996 accounted for most of the change because of a reduction of the Company's capital spending program due to stores sold and closed.
Also, proceeds from the sale of property and equipment were almost $400,000 more in 1996 than in 1995. As the Company completes its program of selling certain Company stores as franchises, it will generate proceeds from the sale of property and equipment; however, $395,000 in 1996 is a non-recurring transaction due to the sale of the lease rights for a Company store lease. In 1997 the Company entered into a five year financing arrangement with a bank which resulted in a net increase of approximately $4,000,000 in proceeds less repayments on borrowed funds as compared to 1996. This generated $1 million in cash from financing as compared to a $3.2 million use in 1996 as funded debt was reduced in 1996 as compared to 1995, when borrowings increased to fund the Redemption.
The Company's material capital commitments consist primarily of long-term obligations (See Notes E and F). Additionally, the Company has a dividend commitment on its Series G Stock of $600,000 in 1998. Funds for repaying these commitments are anticipated to be generated primarily from operations in 1998 and beyond; however, the Company anticipates obtaining financing for at least a portion of its planned capital expenditures in 1998 and subsequent years and anticipates extending its revolving credit agreement with its supplier. If the credit agreement is not extended, the Company will be required to refinance the agreement. The Company has available a $3 million line of credit, none of which was borrowed as of December 31, 1997. This line expires April 30, 1998. The Company believes this is adequate to finance its seasonal working capital needs and will likely renew this or obtain a similar line for 1998 and subsequent years.
At December 31, 1997, the Company had working capital of $3.1 million. The Company has historically operated with a working capital deficit. The Company believes that the nature of its business allows it to operate adequately with a working capital deficit. The factors that contribute to this are the substantial percentage of sales from cash, favorable terms with suppliers, non- cash charges to income resulting from depreciation and amortization expenses, and the line of credit to meet seasonal needs.
The photo processing industry in which the Company operates is introducing new products and services. For example, the 24 mm Advanced Photo System was introduced in 1996, and there is an increasing number of digital imaging products being brought to the market. As demand for some or all of these products and services increases, the Company's commitments for capital expenditures will need to be increased over its historical levels. This could require additional financing, which the Company believes can be obtained. However, it is uncertain as to when these expenditures will be needed and what amounts may be required. The Company is planning capital expenditures of $1.2 million in 1998.
On December 31, 1997, the Company had income tax loss carryforwards, tax credits and deductible temporary differences of approximately $3.9 million. The tax benefit of these carryforwards has a $2.8 million valuation allowance for financial reporting purposes (See Note I). These items, if and when used for tax purposes, preserve liquidity and capital resources because tax payments are reduced by realization of these deferred tax assets. The Company has $10,000,000 of Series G Stock outstanding which is due in 1999 under certain circumstances. (See Note G) These shares can be retired only by an exchange for common shares or from the proceeds of an equity offering. The Company is uncertain at this time as to how or when the Series G Stock will be retired.
All statements, other than statements of historical fact included in this report, which address activities, events or developments which the Company expects or anticipates will or may occur in the future constitute `forward looking statements''within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements are based on certain assumptions and analyses made by the Company in light of its experience and its perception of historical trends, current conditions, and expected future developments, as well as other factors it believes are appropriate in the circumstances. These forward looking statements are subject to all the risks, and uncertainties incident to the Company's business, including, without limitation, competition in the photo processing industry, possible development of new technology affecting the Company's ability to compete, uncertainties with respect to the ability of the Company to expand its business through franchising, new store development, the level of consumer acceptance of the Company's programs and services, continued stability in market prices of key supply items, decline in demand for the products and services offered, continuity of management, liquidity of the franchise system, the ability of the Company to locate and obtain favorable store sites at acceptable lease terms, management's ability to manage its franchisee, lender and supply relationships, economic conditions, the effect of severe weather or natural disasters, and competitive pressure from other retailers. For all of the foregoing reasons, actual results may vary materially from the forward looking statements. The Company assumes no obligation to update any forward looking statements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary data of the Company are included in this report after the signature page.
ITEM 9.
ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III.
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Items 10-13 are incorporated by reference from the definitive proxy statement for the Company's 1998 annual meeting of shareholders to be filed pursuant to Regulation 14A.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
1. Financial Statements: See Financial Statements and Schedules immediately following signature page of this report.
2. Exhibits: See Exhibit Index immediately preceding Exhibits
(b) Reports on Form 8-K. The Company filed no report on Form 8-K during the quarter ended December 31, 1997.
SIGNATURES
MOTO PHOTO, INC.
By /s/ David A. Mason David A. Mason Executive Vice President
Date: March 30, 1998
/s/ Michael F. Adler March 30, 1998 Michael F. Adler Chairman of the Board, Chief Executive Officer, and Director (Principal Executive Officer)
/s/ David A. Mason March 30, 1998 David A. Mason Executive Vice President, Treasurer, Assistant Secretary, and Director (Principal Financial Officer)
/s/ Frank M. Montano March 30, 1998 Frank M. Montano President and Chief Operating Officer
/s/ Frank W. Benson March 30, 1998 Frank W. Benson Director
/s/ D. Lee Carpenter March 30, 1998 D. Lee Carpenter Director
/s/ Leslie Charm March 30, 1998 Leslie Charm Director
/s/ Dexter B. Dawes March 30, 1998 Dexter B. Dawe s Director
/s/ Harry D. Loyle March 30, 1998 Harry D. Loyle Director
/s/ Douglas M. Thomsen March 30, 1998 Douglas M. Thomsen Director
/s/ Alfred E. Lefeld March 30, 1998 Alfred E. Lefeld Vice President and Controller (Principal Accounting Officer)
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Shareholders Moto Photo, Inc.
We have audited the accompanying consolidated balance sheet of Moto Photo, Inc. as of December 31, 1997 and 1996, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Moto Photo, Inc. at December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ Ernst & Young LLP Ernst & Young LLP
Dayton, Ohio February 9, 1998
A. THE COMPANY
Moto Photo, Inc. and its subsidiaries (`the Company'') operate in one business segment-franchising and operation of retail photo processing stores and portrait studios under the trade names and service marks of `ONE HOUR MOTOPHOTO'', `MOTOPHOTO'' and ``ONE HOUR MOTOPHOTO & PORTRAIT STUDIO'' and related marks.
As of December 31, 1995, there were 471 system stores (of which 447 were operational) including 58 operational Company stores, 24 stores in Norway and 56 stores in Canada. As of December 31, 1996, there were 458 system stores (of which 444 were operational), including 51 operational Company stores, 26 stores in Norway, and 55 stores in Canada.
During 1997, the Company closed two stores, refranchised six stores, and awarded 14 franchises. As of December 31, 1997, there were 446 system stores (of which 433 were operational), including 43 operational Company stores, 26 stores in Norway, and 51 stores in Canada.
B. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following is a summary of the Company's significant accounting policies used in the preparation of the accompanying consolidated financial statements.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Moto Photo, Inc., and its subsidiaries. All significant intercompany accounts and transactions have been eliminated.
REVENUE RECOGNITION
Franchise fees are recognized as income when substantially all services and conditions relating to the granting of the franchise have been performed or satisfied. Revenue from territorial development fees is deferred and recognized as stores are opened within the development area. Royalty and company-owned store revenues are recognized as sales are made. Merchandise revenue is recognized when the goods are shipped. Telemarketing revenue is recognized when the services are rendered.
INVENTORY
Inventories are valued at the lower of cost or market. Cost is determined using the average cost method. Inventory is shown net of allowances of $115,000 in 1997 and $126,000 in 1996.
COST OF FRANCHISES AND CONTRACTS ACQUIRED
Cost of franchises and contracts acquired is valued at cost and are amortized by the straight-line method over the term of the agreement. These costs are shown net of accumulated amortization of $646,813 in 1997 and $609,314 in 1996.
STORES FOR RESALE
Certain company-owned stores are offered for sale along with a franchise agreement. The Company generally cannot identify when or if such transactions will occur. Consequently, until a store is franchised, sales, results of operations, and related assets and liabilities are included with those of the company-owned stores. The Company sold six stores in 1997, five stores in 1996, and two stores in 1995 (See Note L).
GOODWILL
The excess of the cost over the fair value of the net operating assets of stores purchased is recorded as goodwill and amortized on a straight-line basis not to exceed 40 years. Goodwill is shown net of accumulated amortization of $2,353,905 in 1997 and $2,756,092 in 1996. The carrying value of goodwill related to operating stores is reviewed if the facts and circumstances suggest that it may be permanently impaired. If this review indicates that goodwill will not be recoverable, as determined by the undiscounted cash flows of the store(s) over the remaining amortization period, the Company's carrying value of the goodwill is adjusted to its estimated fair value. When a decision is made to dispose of a store through sale or closure, the Company's carrying value of the store, including goodwill, is adjusted to its estimated fair value, less costs to sell (See Note L).
PROPERTY AND EQUIPMENT
The costs of equipment and leasehold improvements are capitalized. Maintenance and repairs are charged to expense as incurred while betterments and renewals are capitalized. When equipment is retired or sold, the cost and applicable accumulated depreciation are removed from the respective accounts and the resulting gain or loss is recorded in operations.
Property and equipment, including capitalized leases, are depreciated or amortized by the straight-line method over the estimated useful lives, primarily up to seven years for processing equipment, up to five years for furniture, fixtures, and automobiles, and over the lesser of the remaining term of the lease or the lives of the leasehold improvements.
STOCK-BASED COMPENSATION
The Company accounts for stock based compensation under the principles of Accounting Principles Board Opinion No. 25, `Accounting for Stock issued to Employees''(APB 25) and related Interpretations. When stock options are exercised, the proceeds increase stockholders' equity. No amounts are charged or credited to operations.
INCOME TAXES
The Company accounts for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using tax rates and laws expected to be in effect when the differences are expected to reverse. Valuation allowances are provided against deferred tax assets for which it is `more likely than not'' the assets will not be realized.
PROFIT SHARING PLAN
The Company sponsors a profit sharing plan covering all employees who meet certain eligibility requirements. Company contributions to the Plan are discretionary and subject to the approval of the Board of Directors. Profit sharing expense was $60,000 in 1997, $125,000 in 1996, and $25,000 in 1995.
NET INCOME (LOSS) PER COMMON SHARE - BASIC AND DILUTED Beginning in 1997, income (loss) per common share is computed in accordance with statement of Financial Accounting Standards No. 128, `Earning Per Share'', which became effective for financial statements issued after December 15, 1997. Amounts for prior years have been restated.
Basic income (loss) per common share data are based on the weighted-average number of common shares outstanding during the respective periods. Diluted income (loss) per common share data are based on the weighted-average number of common shares outstanding adjusted to include the effects of potentially dilutive stock options and other common stock equivalents.
B. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
USE OF ESTIMATES
The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
RECLASSIFICATIONS
Certain amounts from prior years have been restated to conform to the presentation used in 1997.
C. PROPERTY AND EQUIPMENT
The following is a summary of property and equipment as of December 31:
Depreciation and amortization expense on property and equipment for the year ended December 31, 1997 was $653,822 ($567,131 in 1996 and $1,118,629 in 1995) (See Note L).
D. OTHER ASSETS
Other assets as of December 31 include the following items, net of accumulated amortization of $237,500 in 1997 and $212,500 in 1996:
E. LONG-TERM DEBT AND OTHER OBLIGATIONS
At December 31, 1997, the Company had an unused line of credit for $2,500,000 at prime plus .75%. The Company pays a commitment fee of .25% per annum on the unused portion of the line of credit. An additional $500,000 line of credit is available to the Company at prime plus 1% which was unused at December 31, 1997. The carrying value of all debt approximates fair value.
The aggregate annual maturities on long-term debt for the five years subsequent to December 31, 1997 are $999,000, $7,002,000, $1,062,000, $1,095,000, and $62,000. Interest paid in 1997, 1996, and 1995 was $436,808, $476,695, and $377,780, respectively.
Long-term debt and borrowings on the line of credit are secured by substantially all of the Company's assets. The revolving credit agreement requires the Company and its franchisees collectively to purchase certain amounts of their requirements for specified products including paper and film through the supplier. Certain of the long-term obligations contain restrictive covenants, all of which the Company was in compliance with at December 31, 1997.
F. LEASES
During 1997, 1996, and 1995, the Company incurred or assumed capital lease obligations aggregating $679,300, $283,106, and $94,766, respectively, in connection with equipment purchases.
The Company also has operating leases for the real estate facilities of several franchised and company-owned stores. The facilities for the franchised stores have been subleased or assigned to the franchisees. The lease agreements generally require the lessee to pay the property taxes, insurance, and maintenance. Under most lease agreements, the lessee is required to pay common area expenses and/or a contingent rental based on a percentage of gross sales. The Company also leases automobiles, office facilities, and equipment under operating lease agreements. Rental expense for operating leases was $2,275,443 in 1997, $2,554,979 in 1996, and $2,854,676 in 1995, net of sublease rentals of $444,734, $409,088, and $406,174, respectively.
In 1996 the Company sold the lease rights for a company-owned store which increased net income by approximately $300,000 for the year.
G. STOCKHOLDERS' EQUITY
The Company has authorized 30,000,000 voting common shares and 1,000,000 non-voting common shares. None of the non-voting common share are outstanding and, unless otherwise stated, any reference herein to common shares refers to voting common shares.
In January 1995, the Company redeemed each of the 417,500 outstanding $1.20 Preferred Shares in exchange for five common shares and $2.00 in cash. This redemption extinguished the $2,004,000, or $4.80 per share, dividends in arrears on the $1.20 Preferred Shares. The difference between the market value of the common shares and cash issued in the redemption was $673,219 less than the aggregate liquidation value and dividend arrearage of the $1.20 Preferred Shares. This is shown as a positive adjustment to loss applicable to common shares in 1995.
Concurrently with the redemption of the $1.20 Preferred Shares, the cumulative non-voting Series E and F Preferred Shares were exchanged for 1,000,000 cumulative non-voting Series G Preferred Shares (`Series G Stock'').
The Series G Stock has a cumulative annual dividend per share of $.40 in 1995, $.50 in 1996, and $.60 in 1997 and 1998. In 1997 $600,000 of dividends were paid on Series G Stock. The Series G Stock has a dividend rate lower than the rate of the Series E and F Preferred Shares. Therefore, the 1997 dividend requirement on income or (loss) applicable to common shares was reduced by $317,172 ($210,710 in 1996 and $92,646 in 1995) of previously accreted Series E and F dividends.
The Series G Stock is redeemable at any time by the Company. The holder can redeem the Series G Stock in 1999. This redemption could be delayed up to one year if the Company's common share price is less than $3.00, in which case the 1999 dividend rate would be $.70 per share. Redemption must be in either the Company's common shares at
90% of the then-current market price or in cash from the proceeds of an equity offering. The holder has the right to refuse redemption in stock. If the stock remains unredeemed, the Company would pay dividends of $.80 per share in 2000, $.90 per share in 2001, and $1.00 per share per year in 2002 and thereafter.
The Company has 835,000 warrants outstanding each of which entitles the holder to purchase one common share for $4.25, subject to adjustments in certain events, through December 31, 1998. The holder of the Series G Stock also holds warrants to purchase 1,000,000 common shares at $2.38 per share, subject to adjustment in certain events, through September 2002. In addition, in 1997 the Company granted 50,000 warrants each of which entitles the holder to purchase one common share for $1.94 through September 2002.
As of December 31, 1997, 8,746,212 shares of common stock were reserved for issuance pursuant to various outstanding options, warrants, and redeemable and convertible securities.
H. STOCK BASED COMPENSATION
The Company has several incentive plans under which the Board of Directors or the Compensation Committee (`the Committee'') of the Board of Directors may grant awards to officers and key managerial, administrative, and professional employees of the Company. Awards may consist of incentive, non-qualified, and deferred compensation stock options, stock appreciation rights, restricted stock and restricted unit grants, performance equity and performance unit grants, and any other stock-based awards, or any combination of these awards.
At December 31, 1997 additional awards aggregating up to 399,034 common shares can be granted on the terms and conditions established by the Committee. The Board of Directors may grant additional non-qualified stock options.
The exercise price of all options granted has been at least equal to the market value at the date of grant. The options are generally exercisable up to five years from the grant date except for 190,485 options which, under certain circumstances, could be exercisable for up to nine years and nine months from the grant date.
The Company has elected to follow APB 25 in accounting for its employee stock options because of the alternative fair value accounting provided for under FAS Statement No. 123, `Accounting for Stock-Based Compensation'' (``FAS 123'') requires use of option valuation models that were not developed for use in valuing employee stock options. Because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized under APB 25.
FAS 123 does not apply to awards granted prior to 1995. Because additional awards in future years are anticipated, the pro forma effects of applying this statement are not necessarily indicative of future amounts.
I. INCOME TAXES
As a result of quasi-reorganization accounting treatment, $69,000 in 1997 and $56,000 in 1996 are charges in lieu of income taxes and payment is not required due to use of tax loss carryforwards. The resulting financial statement benefit is an addition to paid-in capital.
At December 31, 1997, the Company had tax loss carryforwards of $34,000 which expire in 1998 and are restricted to the operations of the entity which created the loss. In addition, the Company has capital loss carryforwards of $1,500,000 which begin to expire and approximately $28,000 of alternative minimum tax credit carryfowards which have no expiration date in 2001.
Realization of the net deferred tax assets depends on generating sufficient taxable income to utilize the tax benefit of the assets prior to expiration of the loss carryforwards. Although realization is not assured, management believes it is more likely than not that the net deferred tax assets will be realized. The Company paid $304,000, $134,000, and $225,000 of income taxes in 1997, 1996, and 1995, respectively.
J. RELATED PARTY TRANSACTIONS
The Company manages a franchise store controlled by certain officers and directors of the Company. The Company derived revenues from this store, including management incentive fees, of approximately $269,000 in 1997, $244,000 in 1996, and $297,000 in 1995.
Another franchise store is owned and managed by a corporation owned and controlled by an officer and his family, from which the Company derived revenue of $110,000 in 1997 and $180,000 in 1996.
The Company leases its headquarters from a partnership which is controlled by certain officers and/or directors for annual rentals of $216,996. Rent expense for each of 1997, 1996, and 1995, was $216,996.
K. CONTINGENCIES
The Company is involved in legal proceedings, arising in the ordinary course of business, which are being contested and defended. Management is of the opinion that there is no contingent liability that would have a material effect on the consolidated financial statements.
L. RESTRUCTURING CHARGE
In 1995 the Company recorded a $5.8 million restructuring charge related to 39 stores it planned to sell as franchises or close. The restructuring charge consisted of $5.7 million of asset impairment reserves related to goodwill ($5.3 million) and property and equipment ($400,000) to reduce the carrying value of the 39 stores to their estimated fair value, less costs to sell and $100,000 for lease terminations. An additional restructuring charge of $510,655 was recorded in 1996, which brought the net book value of the stores to be sold or closed in conformance with management's estimate of what price the stores will bring, less costs to sell, in transactions with prospective franchisees. The 1996 charge consisted of $372,409 of asset impairment reserves related to goodwill and $120,246 to property and equipment and $18,000 for lease terminations.
At December 31, 1997, 20 stores remain to be sold or closed. The Company anticipates the sale of the stores will take approximately two years to substantially complete. The stores remaining to be sold had revenues of $4.3 million and income of $387,000 in 1997. The stores to be closed had revenues of $1.7 million and losses of $157,000 in 1997.
EXHIBIT INDEX
Copies of the following documents are filed as exhibits to this report:
NUMBER DESCRIPTION
3.1 Certificate of Incorporation, as amended (Incorporated by Reference to Exhibit 3.1 to Form 10-K dated March 29, 1995)
3.2 Bylaws, as amended (Incorporated by Reference to Exhibit 3.2 to Form 10-K dated May 5, 1989)
4.1 Certificate of Designation of Series G Preferred Stock (Incorporated by Reference to Exhibit 4.2 to Form 10-K dated March 29, 1995)
4.2 Securities Purchase Agreement dated September 9, 1992 between Moto Photo, Inc. and Fuji Photo Film U.S.A., Inc. and Exhibits C, E, F and G to such Agreement (Incorporated by Reference to Exhibit 28.1 to Form 8-K dated September 9, 1992) *10.1 Employee Incentive Stock Option Plan, as amended (Incorporated by Reference to Exhibit 4.1 to Form S-8 Registration Statement, Registration No. 33-14356)
*10.2 1992 Moto Photo Performance and Equity Incentive Plan (Incorporated by Reference to Appendix A to the Definitive Proxy Statement for the 1992 Moto Photo Annual Meeting of Shareholders)
10.3 Management Agreement dated April 15, 1983, between Foto Fair International, Inc. and National Photo Labs II, Inc. (Incorporated by Reference to Exhibit 10.20 to Form S-1 Registration Statement, Registration No. 2-99676)
10.4 Loan and Security Agreement dated as of February 19, 1997, between Moto Photo, Inc. and The Provident Bank (Incorporated by Reference to Exhibit 10.2 to Form 10-Q dated May 9, 1997)
10.5 Amended Supply Agreement dated as of January 11, 1995 between Moto Photo, Inc. and Fuji Photo Film U.S.A., Inc. (Incorporated by Reference to Exhibit 10.12 to Form 10-K dated March 27, 1996)
10.6 Amendment No. 1 to Warrant Certificate held by Fuji Photo Film U.S.A., Inc. (Incorporated by Reference to Exhibit 10.13 to Form 10-K dated March 29, 1995)
10.7 Project Agreement dated as of February 6, 1998 between Fuji Photo Film U.S.A., Inc., and Moto Photo, Inc.
10.8 Master Lease Agreement dated as of February 6, 1998 between Fuji Photo Film U.S.A., Inc., Moto Photo, Inc., and The Provident Bank
10.9 Lease dated as of August 27, 1990 between Moto Photo, Inc. and Sycamore Partnership (Incorporated by Reference to Exhibit 10.18 to Form 10-K dated March 29, 1991)
*10.10 Employment Agreement effective April 1, 1997 with Michael F. Adler (Incorporated by Reference to Exhibit 10.1 to Form 10-Q dated May 9, 1997)
*10.11 Amendment to Employment Agreement, dated as of April 1, 1997, with Michael F. Adler (Incorporated by Reference to Exhibit 10.1 to Form 10-Q dated August 7, 1997)
*10.12 Employment Agreement dated June 1, 1996 with David A. Mason (Incorporated by Reference to Exhibit 10.2 to Form 10-Q dated August 6, 1996)
*10.13 Amendment to Employment Agreement, dated as of December 23, 1997, with David A. Mason
*10.14 Employment Agreement dated June 1, 1996 with Frank M. Montano (Incorporated by Reference to Exhibit 10.1 to Form 10-Q dated August 6, 1996)
*10.15 Amendment to Employment Agreement, dated as of December 23, 1997, with Frank M. Montano
*10.16 Employment Agreement effective as of September 1, 1992 with Paul Pieschel (Incorporated by Reference to Exhibit 10.31 to Form 10-K dated March 25, 1993)
*10.17 Bonus Arrangements for Certain Officers
11.0 Statement Re: Computation of Per Share Amounts (Included with the financial statements and supplementary data filed after the signature page of this report)
22.0 List of subsidiaries of the Company (Incorporated by Reference to Exhibit 22 to Form 10-K dated March 27, 1996)
23.0 Consents of Ernst & Young, LLP
27.0 Financial Data Schedule