UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2006
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________________ to ________________
Commission file number: 000-32319
ALLIANCE DISTRIBUTORS HOLDING INC.
(Exact name of registrant as specified in its charter)
Delaware 33-0851302
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
15-15 132nd Street, College Point, New York 11356
(Address of principal executive offices) (Zip Code)
(718) 747-1500
(Registrant's telephone number, including area code)
[None]
(Former name, former address and former fiscal year, if changed since
last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act.
Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [X]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Class Outstanding at August 8, 2006
--------------------------------------- -----------------------------
Common Stock, $.001 par value per share 48,721,065 shares
INDEX
Pages
PART I - FINANCIAL INFORMATION
Item 1 - Financial Statements
Balance Sheets at June 30, 2006 (Unaudited)
and December 31, 2005 (Audited) 3
Statements of Operations for the three and six
months ended June 30, 2006 and 2005 (Unaudited) 4
Statement of Stockholders' Equity for the six
months ended June 30, 2006 (Unaudited) 5
Statements of Cash Flows for the six months
ended June 30, 2006 and 2005 (Unaudited) 6
Notes to Financial Statements (Unaudited) 7-9
Item 2 - Management's Discussion and Analysis of Financial Condition
and Results of Operations 10-14
Item 3 - Quantitative and Qualitative Disclosures about Market Risk 14
Item 4 - Controls and Procedures 14
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings 14
Item 1A - Risk Factors 15-18
Item 6 - Exhibits 18
Signatures 19
2
Part I - Financial Information
Item 1 - Financial Statements
ALLIANCE DISTRIBUTORS HOLDING INC.
Balance Sheets
June 30, December 31,
2006 2005
(Unaudited) (Audited)
------------ ------------
ASSETS
Current assets:
Cash $ 74,383 $ 251,844
Accounts receivable, net of allowance for doubtful
accounts of approximately $206,000 and $181,000 at
June 30, 2006 and December 31, 2005, respectively 4,248,642 5,526,444
Inventory 5,096,029 5,368,967
Due from vendors 347,019 739,453
Prepaid acquisition and proposed offering costs -- 161,823
Prepaid expenses and other current assets 510,795 224,665
Deferred tax asset 170,000 155,000
------------ ------------
Total current assets 10,446,868 12,428,196
Property and equipment, net 283,323 370,875
Other assets 120,153 71,300
------------ ------------
$ 10,850,344 $ 12,870,371
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Note payable-bank $ 3,581,500 $ 5,135,167
Accounts payable 3,698,778 4,033,497
Current portion of long term obligations 17,028 18,468
Accrued expenses and other current liabilities 150,404 393,830
------------ ------------
Total current liabilities 7,447,710 9,580,962
Long term obligations 7,376 12,126
Deferred lease obligation 53,205 25,785
Commitments and contingencies
Stockholders' equity:
Series A Convertible Non-Redeemable Preferred Stock,
$.001 par value;8,530,348 and 8,615,348 shares authorized;
261,663 and 346,663 shares issued and outstanding
at June 30, 2006 and December 31, 2005, respectively 262 347
Common Stock, $.001 par value; 100,000,000 shares
authorized; 48,721,065 and 47,368,756 shares
issued and outstanding at June 30, 2006 and
December 31, 2005, respectively 48,721 47,369
Additional paid-in capital 3,334,299 3,224,521
Accumulated deficit (41,229) (20,739)
------------ ------------
Total stockholders' equity 3,342,053 3,251,498
------------ ------------
$ 10,850,344 $ 12,870,371
============ ============
See notes to financial statements.
3
ALLIANCE DISTRIBUTORS HOLDING INC.
Statements of Operations (Unaudited)
For the three and six months ended June 30, 2006 and 2005
Three months ended June 30, Six months ended June 30,
--------------------------- ---------------------------
2006 2005 2006 2005
------------ ------------ ------------ ------------
Net sales $ 13,268,597 $ 12,224,803 $ 26,587,196 $ 23,113,638
Cost of goods sold 11,617,158 11,154,292 23,376,846 20,800,790
------------ ------------ ------------ ------------
Gross profit 1,651,439 1,070,511 3,210,350 2,312,848
Operating expenses:
Selling, general and administrative expenses 1,445,957 1,274,402 2,721,150 2,551,804
Terminated transaction costs -- -- 257,457 --
Other income (108,772) -- (108,772) --
------------ ------------ ------------ ------------
Total operating expenses 1,337,185 1,274,402 2,869,835 2,551,804
------------ ------------ ------------ ------------
Income (loss) from operations 314,254 (203,891) 340,515 (238,956)
Interest expense 185,816 126,809 373,873 220,422
------------ ------------ ------------ ------------
Income (loss) before provision for (benefit from)
income taxes 128,438 (330,700) (33,358) (459,378)
Provision for (benefit from) income taxes 55,343 5,103 (12,868) 6,103
------------ ------------ ------------ ------------
Net income (loss) $ 73,095 $ (335,803) $ (20,490) $ (465,481)
------------ ------------ ------------ ------------
Net income (loss) per share - basic $ .00 $ (.01) $ .00 $ (.01)
============ ============ ============ ============
Net income (loss) per share - diluted $ .00 $ (.01) $ .00 $ (.01)
============ ============ ============ ============
Weighted-average common shares outstanding - basic 48,721,065 46,417,098 48,444,632 46,417,098
============ ============ ============ ============
Weighted-average common shares outstanding - diluted 50,771,727 46,417,098 48,444,632 46,417,098
============ ============ ============ ============
See notes to financial statements.
4
ALLIANCE DISTRIBUTORS HOLDING INC.
Statement of Stockholders' Equity (Unaudited)
For the six months ended June 30, 2006
Preferred Stock A Common Stock Additional Total
-------------------------- ------------------------- Paid In Accumulated Stockholders'
Shares Amount Shares Amount Capital Deficit Equity
----------- ----------- ----------- ----------- ----------- ----------- -----------
Balance, January 1, 2006 346,663 $ 347 47,368,756 $ 47,369 $ 3,224,521 $ (20,739) $ 3,251,498
Conversion of Preferred
Stock A into Common Stock (85,000) (85) 1,352,309 1,352 (1,267) -- --
Stock option compensation
expense -- -- -- -- 111,045 -- 111,045
Net loss -- -- -- -- -- (20,490) (20,490)
----------- ----------- ----------- ----------- ----------- ----------- -----------
Balance, June 30, 2006 261,663 $ 262 48,721,065 $ 48,721 $ 3,334,299 $ (41,229) $ 3,342,053
=========== =========== =========== =========== =========== =========== ===========
See notes to financial statements.
5
ALLIANCE DISTRIBUTORS HOLDING INC.
Statements of Cash Flows (Unaudited)
For the six months ended June 30, 2006 and 2005
Six months ended June 30,
----------------------------
2006 2005
------------ ------------
CASH FLOWS PROVIDED BY (USED IN) OPERATING ACTIVITIES:
Net loss $ (20,490) $ (465,481)
ADJUSTMENTS TO RECONCILE NET LOSS TO NET CASH PROVIDED BY
(USED IN) OPERATING ACTIVITIES:
Deferred rent 27,420 4,956
Depreciation and amortization 64,157 53,079
Bad debt expense 25,847 100,000
Stock option compensation expense 111,045 30,666
Interest amortization of deferred financing costs 60,000 34,000
Deferred taxes (15,000) --
CHANGES IN ASSETS AND LIABILITIES:
(Increase) decrease in assets
Accounts receivable 1,251,955 (710,925)
Inventory 272,938 (1,317,230)
Due from vendors 392,434 (40,458)
Prepaid acquisition and proposed offering costs 161,823 --
Prepaid expenses and other current assets (158,322) 16,291
Increase (decrease) in liabilities
Accounts payable (334,719) 381,579
Accrued expenses and other current
liabilities (243,426) 14,008
------------ ------------
Net cash provided by (used in) operating activities 1,595,662 (1,899,515)
------------ ------------
CASH FLOWS USED IN INVESTING ACTIVITIES:
Purchase of property and equipment (154,413) (55,662)
Increase in other assets (58,853) (12,500)
------------ ------------
Net cash used in investing activities (213,266) (68,162)
------------ ------------
CASH FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES:
Proceeds from note payable - bank 25,363,265 23,635,275
Repayments of note payable - bank (26,916,932) (21,840,073)
Payments for registration costs -- (16,250)
Repayment of long-term obligations (6,190) (15,840)
------------ ------------
Net cash provided by (used in) financing activities (1,559,857) 1,763,112
------------ ------------
NET DECREASE IN CASH (177,461) (204,565)
CASH, beginning of period 251,844 220,605
------------ ------------
CASH, end of period $ 74,383 $ 16,040
============ ============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid $ 339,636 $ 182,406
============ ============
Income tax paid $ 85,657 $ 2,013
============ ============
See notes to financial statements.
6
ALLIANCE DISTRIBUTORS HOLDING INC.
Notes to Financial Statements (Unaudited)
Note 1 - THE COMPANY AND INTERIM FINANCIAL STATEMENTS
Alliance Distributors Holding Inc. (the "Company" or "Alliance") is a
distributor of video game consoles, peripherals, accessories and software to
customers throughout the United States for most key manufacturers and third
party publishers in the video game industry. The Company operates as a single
segment.
On July 21, 2005, the Company and Abrams/Gentile Entertainment Inc. ("Age")
entered into an operating agreement in which the Company and Age became members
in Alliance Age LLC, a limited liability company formed in Delaware, to set
forth the terms on which the parties will develop and commercialize products
they mutually agree upon from time to time. The Company owns 65% of Alliance Age
LLC. As of June 30, 2006, Alliance Age LLC was inactive.
The accompanying unaudited financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of America
for interim financial information and pursuant to the rules and regulations of
the Securities and Exchange Commission ("SEC"). Certain information and footnote
disclosures normally included in financial statements prepared in accordance
with accounting principles generally accepted in the United States of America
have been omitted. This Form 10-Q should be read in conjunction with the
Company's financial statements and notes included in the 2005 Annual Report on
Form 10-KSB. In the opinion of management, all material adjustments, consisting
of normal recurring adjustments, considered necessary for a fair presentation,
have been included in the accompanying unaudited financial statements.
The results of operations for the interim periods are not necessarily indicative
of the results that maybe expected for the full year ending December 31, 2006.
Note- 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Allowance for Doubtful Accounts
The Company establishes credit terms for new clients based upon management's
review of their credit information and projects terms, performs ongoing credit
evaluations of its customers, adjusting credit terms when management believes
appropriate based upon payment history and an assessment of their current credit
worthiness. The Company records an allowance for doubtful accounts for estimated
losses resulting from the inability of its clients to make required payments.
The Company determines this allowance by considering a number of factors,
including the length of time trade accounts receivable are past due, previous
loss history, estimate of the client's current ability to pay its obligation to
the Company, and the condition of the general economy and the industry as a
whole. While credit losses have generally been within expectations and the
provisions established, the Company cannot guarantee that credit loss rates in
the future will be consistent with those experienced in the past. In addition,
the Company has credit exposure if the financial condition of one of its major
clients were to deteriorate. In the event that the financial condition of its
clients were to deteriorate, resulting in an impairment of their ability to make
payments, additional allowances may be necessary. It is reasonably possible that
the Company's estimate of the allowance for doubtful accounts will change. As of
June 30, 2006 and December 31, 2005, the Company's allowance for doubtful
accounts has a balance of approximately $206,000 and $181,000, respectively.
Inventory
Inventory consists entirely of finished goods held for sale and is reported at
the lower of cost or market, on the average cost basis. The Company receives
price protection from its suppliers for merchandise that may be slow moving or
aged. The Company evaluates the adequacy of its slow moving or aged inventory
quarterly and writes down its inventory to fair value based upon the price
protection received or current market value. While write-downs have been within
expectations and the provisions established, the Company cannot guarantee that
it will continue to experience the same level of write-downs as in the past. At
times, the Company makes advance payments to vendors to procure and ensure
delivery of certain high demand products. Such deposits are reflected as due
from vendors in the balance sheet. The Company does not offer warranties to its
customers but will accept returns of product claimed to be defective and
reimburse the customers for the full purchase price. The majority of the
Company's suppliers in turn accept these returns from us. There are no reserves
for warranties as of June 30, 2006 and December 31, 2005.
Income Taxes
The Company accounts for income taxes using the liability method which requires
the recognition of deferred tax assets or liabilities for the temporary
differences between the financial reporting and tax bases of the Company's
assets and liabilities and for tax carryforwards at enacted statutory rates in
effect for the years in which the differences are expected to reverse. The
effect on deferred taxes of a change in tax rates is recognized in income in the
period that includes the enactment date. In addition, valuation allowances are
established when necessary to reduce deferred tax assets to the amounts expected
to be realized.
Net Income (Loss) Per Share
Basic net income (loss) per share is computed by dividing net income (loss) by
the weighted average number of common shares outstanding for the period. Diluted
net income per share is computed by dividing the net income by the weighted
average number of common shares and common equivalent shares outstanding during
the period.
7
The denominator for diluted net income per share for the three months ended June
30, 2006 includes 205,882 and 1,844,780 of shares issuable upon conversion of
warrants and Series A Convertible Non-Redeemable Preferred Stock, respectively.
Common equivalents for the six months ended June 30, 2006 exclude 2,266,788 for
shares issuable upon exercise of warrants and for shares issuable upon
conversion of Series A Convertible Non-Redeemable Preferred Stock since their
effect would be anti-dilutive. Common equivalents for the three and six months
ended June 30, 2005 exclude 2,828,641 and 3,013,807 shares, respectively, for
shares issuable upon exercise of warrants and for shares issuable upon
conversion of Series A Convertible Non-Redeemable Preferred Stock since their
effect would be anti-dilutive.
Stock Based Compensation
Previously, pursuant to Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees," the Company accounted for stock based employee
compensation arrangements using the intrinsic value method. Accordingly, no
compensation expense was recorded in the financial statements with respect to
option grants, since the options were granted at/or above market value.
Effective January 1, 2006, the Company adopted SFAS No. 123 (revised 2004),
"Share Based Payment" ("SFAS No. 123R") which eliminates the use of APB 25 and
the intrinsic value method of accounting, and requires companies to recognize
the cost of employee services received in exchange for awards of equity
instruments, based on the grant date fair value of those awards, in the
financial statements. The Company has adopted the modified prospective method
whereby compensation cost is recognized in the financial statements beginning
with the effective date based on the requirements of SFAS No. 123R for all
share-based payments granted after that date and for all unvested awards granted
prior to that date.
Had compensation costs for the Company's stock option grants to employees been
determined based on the fair value at the grant dates for awards under these
plans in accordance with SFAS No. 123R, the Company's net income (loss) and
basic and diluted net income (loss) per share would have been as follows:
For the three months ended For the six months ended
June 30, June 30,
2006 2005 2006 2005
---------------------------- --------------------------
(Unaudited) (Unaudited)
Net income (loss), as reported $ 73,095 $(335,803) $(20,490) $(465,481)
Add: stock-based employee compensation expense, included
in reported net income (loss), net of taxes 29,463 -- 58,927 --
Deduct: stock-based employee compensation expense
determined under fair value based method, net of taxes (29,463) (54,833) (58,927) (108,041)
--------- --------- -------- ---------
Proforma net income (loss) $ 73,095 $(390,636) $(20,490) $(573,522)
========= ========= ======== =========
Net income (loss) per share:
Basic and diluted net income (loss) per share, as reported $ 0.00 $ (0.01) $ 0.00 $ (0.01)
========= ========= ========= =========
Pro forma basic and diluted net income (loss) per share $ 0.00 $ (0.01) $ 0.00 $ (0.01)
========= ========= ========= =========
The fair value of the options-pricing model was calculated with the following
weighted-average assumptions used for grants during the six months ended June
30, 2005: risk-free interest rate 4.25-4.5%; expected life 6.5 years; expected
volatility 55-126%. The fair value generated by the Black-Scholes model may not
be indicative of the future benefit, if any, that may be received by the option
holder. There were no grants of options during the three and six months ended
June 30, 2006.
Note 3 - FINANCING AGREEMENTS
The Company has entered into a financing agreement with Rosenthal & Rosenthal,
Inc. ("Rosenthal") dated November 11, 2004 and amended on November 1, 2005 (the
"Agreement"). Under the Agreement, Rosenthal may in its discretion lend to the
Company up to $10,000,000, which is the maximum credit under the facility, based
on eligible inventory and receivables. All borrowings are due on demand, are
secured by substantially all of the assets of the Company and are subject to the
Company's compliance with certain financial covenants. The Company's CEO and the
Company's President have signed limited guaranties in respect of borrowings
under the Agreement.
The amendment dated November 1, 2005 among other things increased the maximum
credit under the facility from $5,000,000 to $10,000,000 and reduced the
interest rate on borrowings by 0.5%.
8
The Agreement terminates November 30, 2007 unless terminated by Rosenthal on 30
days' notice. Interest accrues on outstanding borrowings at the prime rate (but
not less than 4.75%) plus 1.5%. At June 30, 2006, the interest rate on
borrowings outstanding was 9.75%. In addition, the Company will pay the lender
on each anniversary date an annual fee of 1% of the maximum credit which is
amortized over one year, and a monthly administrative fee of $1,000. The
financing expense for the annual fee recorded for the three months ended June
30, 2006 and 2005 amounted to approximately $25,000 and $12,500, respectively,
and for the six months ended June 30, 2006 and 2005 amounted to approximately
$50,000 and $25,000, respectively. At June 30, 2006 and December 31, 2005, the
principal amount outstanding under the facility was $3,581,500 and $5,135,167,
respectively.
In connection with establishing the Agreement, the Company issued to Rosenthal a
warrant (the "Warrant") to purchase 500,000 shares of common stock at $0.10 per
share. The Warrant expires on November 30, 2010. On notice by the Company the
Warrants will expire earlier if the closing price of the common stock during a
period designated in the Warrants is not less than $0.40 per share. The Warrants
may be exercised for cash or on a cashless basis (i.e., by deducting from the
number of shares otherwise issuable on exercise a number of shares that have a
then market value equal to the exercise price). The Company recorded a deferred
financing cost of approximately $60,000 in the fourth quarter 2004, representing
the fair value of the warrants, which will be amortized over the life of the
financing agreement of three years. The financing expense recorded for the three
months ended June 30, 2006 and 2005 amounted to approximately $5,000 and $4,500,
respectively, and for the six months ended June 30, 2006 and 2005 amounted to
approximately $10,000 and $9,000, respectively.
Under the terms of the Agreement, the Company is required to maintain a
specified level of net worth, working capital and debt ratios as defined. On
March 21, 2006, the Company and Rosenthal agreed to amend the covenants,
effective December 31, 2005. On August 9, 2006, the Company and Rosenthal agreed
to amend and increase the capital expenditures covenant, effective June 30,
2006. The Company was in compliance with all its covenants at June 30, 2006.
The Company believes that it will have sufficient liquidity for the next twelve
months and the foreseeable future. However, the Company would be materially and
adversely affected if Rosenthal demands payment of these borrowings under the
Agreement and the Company is unable to refinance these borrowings.
Note 4 - LITIGATION
On August 19, 2004 a complaint was filed by Radio Wave LLC ("Plaintiff"), in the
Supreme Court of the State of New York, County of New York, against the
predecessor entity, Essential Reality, Inc., Essential Reality, LLC and David
Devor, a former officer and a current employee of the Company, for rent and
costs relating to premises formerly occupied by the Company. Plaintiff seeks to
recover $150,416 for the period up to August 31, 2004, plus additional amounts
to be determined by the Court for the period subsequent to August 31, 2004.
Plaintiff also seeks to recover $50,000 in expenses and attorney fees plus
additional amounts to be determined by the Court. On June 27, 2006, the Court
dismissed a motion for summary judgment brought by Plaintiff. The Company is
currently in settlement discussions with the Plaintiff and has provided a
reserve for its estimate of the loss.
Note 5 - TERMINATED TRANSACTION COSTS
On April 26, 2006, the Company announced that it will not buy Foto Electric
Supply Co., Inc. (Fesco). An agreement by the Company to buy Fesco expired by
its terms on February 28, 2006, and subsequent discussions to extend and amend
the agreement have ended. The Company recorded a charge of approximately
$257,000 in the first quarter of 2006 for its costs in the terminated
transaction.
Note 6 - OTHER INCOME
Other income was primarily the result of insurance proceeds for replacement
value of assets that were damaged as a result of a fire near the Company's 132nd
Street location in excess of book value.
Note 7 - COMMITMENTS
On June 8, 2006, the Company entered into an Agreement with Three Boroughs LLC
to lease approximately 25,000 square feet of space located at 1160 Commerce
Avenue, Bronx, New York, of which approximately 18,000 and 7,000 square feet
will be utilized for warehouse and office space, respectively. The lease has a
five-year term commencing on June 1, 2006 and expiring on May 31, 2011, unless
otherwise extended by the Company under an option to extend the term for an
additional five-year term expiring on May 31, 2016. The annual base rent is
$295,000 for the first year of the term (payable in 12 equal monthly payments of
approximately $24,583, with an abatement equal to approximately $24,583 for the
first rental payment) and increases 3.5% on June 1st of each year beginning with
June 1, 2007. In the event the Company exercises the option, the annual base
rent will continue to increase at the 3.5% annual rate.
On June 13, 2006, the Company as lessee entered into a lease agreement for
approximately 7,000 square feet of space located at 2310 NW 102 Place, Miami,
Florida, of which approximately 5,000 and 2,000 square feet will be used for
warehouse and showroom/office space, respectively. The lease has a five-year
term commencing on June 1, 2006. The annual base rent is $56,400 for the first
two years of the term (payable in monthly payments of $4,700), and increases
2.0% on June 1st of each year beginning with June 1, 2008. In addition, the
Company must pay condominium maintenance fees (currently $600 per month), real
property taxes (currently $800 per month) and all applicable sales tax.
9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD - LOOKING STATEMENTS
The following discussion of our financial condition and results of operations
should be read together with the financial statements and related notes included
elsewhere in this report. Some of the statements in this section that are not
historical facts are forward-looking statements. You are cautioned that the
forward-looking statements contained in this section are estimates and
predictions, and that our actual results could differ materially from those
anticipated in the forward-looking statements due to risks, uncertainties or
actual events differing from the assumptions underlying these statements. The
risks, uncertainties, and assumptions include, but are not limited to, those
disclosed in our annual report on Form 10-KSB for our fiscal year ended December
31, 2005.
OVERVIEW
Our distribution revenues are derived from the sale of interactive video games
and gaming products for all key manufacturers and third-party software titles,
accessories and hardware. Operating margins in our distribution business are
dependent on the mix of software and hardware sales, with software generating
higher margins than hardware.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Certain of the Company's accounting policies require the application of
significant judgment by management in selecting the appropriate assumptions for
calculating financial estimates. By their nature, these judgments are subject to
an inherent degree of uncertainty. These judgments are based on historical
experience, observation of trends in the industry, information provided by
customers and information available from other outside sources, as appropriate.
Critical accounting policies include:
Revenue Recognition - The Company recognizes sales upon shipment of products to
customers as title and risk of loss pass upon shipment and collectibility is
reasonably assured. Provisions for estimated uncollectible discounts and rebates
to customers, estimated returns and allowances and other adjustments are
provided for in the same period the related sales are recorded. While such
amounts have been within expectations and the provisions established, the
Company cannot guarantee that it will continue to experience the same rates as
in the past.
Accounts Receivable - Accounts Receivable as shown on the Balance Sheet are net
of allowances and anticipated discounts. The Company establishes credit terms
for new clients based upon management's review of their credit information and
projects terms, performs ongoing credit evaluations of its customers, adjusting
credit terms when management believes appropriate based upon payment history and
an assessment of their current credit worthiness. The allowance for doubtful
accounts is determined through analysis of the aging of accounts receivable at
the date of the financial statements for estimated losses resulting from the
inability of its clients to make required payments. The Company determines this
allowance by considering a number of factors, including the length of time trade
accounts receivable are past due, previous loss history, estimate of the
client's current ability to pay its obligation to the Company, and the condition
of the general economy and the industry as a whole. While credit losses have
generally been within expectations and the provisions established, the Company
cannot guarantee that credit loss rates in the future will be consistent with
those experienced in the past. In addition, the Company has credit exposure if
the financial condition of one of its major clients were to deteriorate. In the
event that the financial condition of its clients were to deteriorate, resulting
in an impairment of their ability to make payments, additional allowances may be
necessary. It is reasonably possible that the Company's estimate of the
allowance for doubtful accounts will change. As of June 30, 2006 and December
31, 2005, the Company's allowance for doubtful accounts has a balance of
approximately $206,000 and $181,000, respectively.
Inventories - Inventory is stated at the lower of cost or market, cost being
determined on the average cost basis. The Company receives price protection from
its suppliers for merchandise that may be slow moving or aged. The Company
evaluates the adequacy of its slow moving or aged inventory quarterly and writes
down its inventory to fair value based upon the price protection received or
current market value. While write-downs have been within expectations and the
provisions established, the Company cannot guarantee that it will continue to
experience the same level of write-downs as in the past. The Company does not
offer warranties to its customers but will accept returns of product claimed to
be defective and reimburse the customers for the full purchase price. The
majority of the Company's suppliers in turn accept these returns from us. There
are no reserves for warranties as of June 30, 2006 and December 31, 2005.
Income Taxes - At December 31, 2005, the Company had federal and state net
operating loss carryforwards (NOL's) of approximately $5,481,000. In accordance
with SFAS No. 109, "Accounting for Income Taxes", the Company establishes
valuation allowances if it is "more likely than not" that the Company will not
be able to utilize it to offset future taxes. The Company has established a
valuation allowance of $2,356,600 at December 31, 2005 due to the uncertainty
surrounding the realization of the NOL's which resulted from a transaction under
a Share Exchange Agreement in June 2004 by and among the Company (formerly
Essential Reality, Inc.) and Jay Gelman, Andre Muller and Francis Vegliante
("Exchange Agreement"). Pursuant to IRC Section 382 of the Tax Reform Act of
1986 the utilization of NOL's is limited in the case of certain transactions
including significant changes in ownership interests. The Company has determined
that based upon the terms of the Exchange Agreement, an ownership change
pursuant to this Act has occurred and as a result, the NOL's are significantly
limited.
FLUCTUATIONS IN OPERATING RESULTS AND SEASONALITY
We have experienced fluctuations in quarterly operating results as a result of
the timing of the introduction of new titles; variations in sales of titles
developed for particular platforms; market acceptance of our titles; sequels or
enhancements of existing titles; projected and actual changes in platforms; the
timing and success of title introductions by our competitors; product returns;
changes in pricing policies by us and our competitors; order cancellations; and
delays in product shipment. Sales of our titles are also seasonal, with peak
shipments typically occurring in the fourth calendar quarter as a result of
increased demand for titles during the holiday season. Quarterly comparisons of
operating results are not necessarily indicative of future operating results.
10
RESULTS OF OPERATIONS
The following table shows each specified item as a dollar amount and as a
percentage of net sales for the three months and six ended June 30, 2006 and
2005, and should be read in conjunction with the financial statements included
elsewhere in this Quarterly Report on Form 10-Q:
Three months Three months
ended ended
June 30, June 30,
2006 2005
(Thousands) (Thousands)
------------------------ -----------------------
Net sales $ 13,268 100.0% $ 12,225 100.0%
Cost of goods sold 11,617 87.5% 11,154 91.2%
---------- ---------- ---------- ----------
Gross profit 1,651 12.5% 1,071 8.8%
Operating expenses:
Selling, general and
administrative expenses 1,446 10.9% 1,275 10.4%
Other income (109) (.8%) -- .0%
---------- ---------- ---------- ----------
Total operating expenses 1,337 10.1% 1,275 10.4%
---------- ---------- ---------- ----------
Income (loss) from operations 314 2.4% (204) (1.6%)
Interest expense 186 1.4% 127 1.1%
---------- ---------- ---------- ----------
Income (loss) before income taxes 128 1.0% (331) (2.7%)
Income taxes 55 .4% 5 .0%
---------- ---------- ---------- ----------
Net income (loss) $ 73 .6% $ (336) (2.7%)
========== ========== ========== ==========
Three Months Ended June 30, 2006 compared to Three Months Ended June 30, 2005
Net sales increased by $1,043,794, or 8.5%, from $12,224,803 for the three
months ended June 30, 2005 to $13,268,597 for the three months ended June 30,
2006. The growth in net sales was primarily due to the increase in sales with
our existing customers, as well as an increase in our customer base.
Cost of goods sold increased by $462,866, or 4.1%, from $11,154,292 for the
three months ended June 30, 2005 to $11,617,158 for the three months ended June
30, 2006. The increase was consistent with revenue growth. Gross profit as a
percentage of net sales increased to 12.5% for the three months ended June 30,
2006 from 8.8% for the three months ended June 30, 2005. This increase in margin
is primarily a function of an increase in the sales mix of higher margin
products plus increased margins related to sales of PlayStation 2 and
PlayStation Portable hardware and software. Cost of goods sold excludes the
distribution costs of purchasing, receiving, inspection, warehousing and
handling costs; we include these costs in our selling, general and
administrative expenses. Our gross margins may not be comparable to those of
other entities since some entities include these distribution costs in the cost
of goods sold. These distribution costs were $343,237 and $265,270 for the three
months ended June 30, 2006 and 2005, respectively.
Selling, general and administrative expenses increased by $171,555, or 13.5%,
from $1,274,402 for the three months ended June 30, 2005 to $1,445,957 for the
three months ended June 30, 2006. The increase was primarily the result of
increases in freight out expenses of $75,633 due primarily to fuel increases,
payroll and related costs of $54,432, and stock option compensation expense of
$51,689. Selling, general and administrative expenses as a percentage of net
sales increased to 10.9% for the three months ended June 30, 2006 from 10.4% for
the three months ended June 30, 2005. For the three months ended June 30, 2006,
selling, general and administrative expenses were comprised of the following:
$204,986 in selling expenses, $343,237 in distribution costs and $897,734 in
general and administrative expenses. For the three months ended June 30, 2005,
selling, general and administrative expenses were comprised of the following:
$206,018 in selling expenses, $265,270 in distribution costs and $803,114 in
general and administrative expenses.
11
Other income of $108,772, or .8% of sales, was primarily the result of insurance
proceeds for replacement value of assets that were damaged as a result of a fire
near the Company's 132nd Street location in excess of book value.
Interest expense increased by $59,007, or 46.5%, from $126,809 for the three
months ended June 30, 2005 to $185,816 for the three months ended June 30, 2006.
The increase was primarily due to higher interest rates on bank borrowings and
increased interest amortization of deferred financing costs during the three
months ended June 30, 2006.
Six Months Ended June 30, 2006 compared to Six Months Ended June 30, 2005
Six months Six months
ended ended
June 30, June 30,
2006 2005
(Thousands) (Thousands)
------------------------ -----------------------
Net sales $ 26,587 100.0% $ 23,114 100.0%
Cost of goods sold 23,377 87.9% 20,801 90.0%
---------- ---------- ---------- ----------
Gross profit 3,210 12.1% 2,313 10.0%
Operating expenses:
Selling, general and
administrative expenses 2,721 10.2% 2,552 11.0%
Terminated transaction costs 258 1.0% -- .0%
Other income (109) (.4%) -- .0%
---------- ---------- ---------- ----------
Total operating expenses 2,870 10.8% 2,552 11.0%
---------- ---------- ---------- ----------
Income (loss) from operations 340 1.3% (239) (1.0%)
Interest expense 373 1.4% 220 1.0%
---------- ---------- ---------- ----------
Loss before income taxes (33) (.1%) (459) (2.0%)
Income taxes (13) .0% 6 .0%
---------- ---------- ---------- ----------
Net loss $ (20) (.1%) $ (465) (2.0%)
========== ========== ========== ==========
Net sales increased by $3,473,558, or 15.0%, from $23,113,638 for the six months
ended June 30, 2005 to $26,587,196 for the six months ended June 30, 2006. The
growth in net sales was primarily due to the increase in sales with our existing
customers, as well as an increase in our customer base.
Cost of goods sold increased by $2,576,056, or 12.4%, from $20,800,790 for the
six months ended June 30, 2005 to $23,376,846 for the six months ended June 30,
2006. The increase was consistent with revenue growth. Gross profit as a
percentage of net sales increased to 12.1% for the six months ended June 30,
2006 from 10.0% for the six months ended June 30, 2005. This increase in margin
is primarily a function of an increase in the sales mix of higher margin
products plus increased margins related to sales of PlayStation 2 and
PlayStation Portable hardware and software. Cost of goods sold excludes the
distribution costs of purchasing, receiving, inspection, warehousing and
handling costs; we include these costs in our selling, general and
administrative expenses. Our gross margins may not be comparable to those of
other entities since some entities include these distribution costs in the cost
of goods sold. These distribution costs were $654,265 and $518,580 for the six
months ended June 30, 2006 and 2005, respectively.
Selling, general and administrative expenses increased by $169,346, or 6.6%,
from $2,551,804 for the six months ended June 30, 2005 to $2,721,150 for the six
months ended June 30, 2006. The increase was primarily the result of increases
in freight out expenses of $136,115 due primarily to fuel increases, payroll and
related costs of $78,521 and stock option compensation expense of $80,379 offset
by a decrease in professional fees of $105,730 consisting primarily of decreased
accounting and legal fees related to Company SEC filings. Selling, general and
administrative expenses as a percentage of net sales decreased to 10.2% for the
six months ended June 30, 2006 from 11.0% for the six months ended June 30,
2005. For the six months ended June 30, 2006, selling, general and
administrative expenses were comprised of the following: $395,737 in selling
expenses, $654,265 in distribution costs and $1,671,148 in general and
administrative expenses. For the six months ended June 30, 2005, selling,
general and administrative expenses were comprised of the following: $370,777 in
selling expenses, $518,580 in distribution costs and $1,662,447 in general and
administrative expenses.
Terminated transaction costs of $257,457, or 1.0% of sales, were expensed to
operations in the first quarter of 2006 because of the Company's determination
that it will not buy Foto Electric Supply Co., Inc. (Fesco). An agreement by the
Company to buy Fesco expired by its terms on February 28, 2006, and subsequent
discussions to extend and amend the agreement have ended.
12
Other income of $108,772, or .8% of sales, was primarily the result of insurance
proceeds for replacement value of assets that were damaged as a result of a fire
near the Company's 132nd Street location in excess of book value.
Interest expense increased by $153,451, or 69.6%, from $220,422 for the six
months ended June 30, 2005 to $373,873 for the six months ended June 30, 2006.
The increase was primarily due to increased borrowings as well as higher
interest rates on bank borrowings during the first six months of 2006. The
increased borrowing levels were the result of increased sales volume that
required higher inventory levels and increased accounts receivable.
LIQUIDITY AND CAPITAL RESOURCES
For the six months ended June 30, 2006 net cash provided by operating activities
was $1,595,662. Net cash provided by operations for the six months ended June
30, 2006 consisted of a net loss of $20,490 and included the following changes
in operating assets and liabilities: a decrease in accounts receivable of
$1,251,955, a decrease in inventory of $272,938, a decrease in due from vendors
of $392,434, a decrease in prepaid acquisition and proposed offering costs of
$161,823, a decrease in accounts payable of $334,719 and a decrease in accrued
expenses and other current liabilities of $243,426. The decrease in accounts
receivable of $1,251,955 was primarily the result of lower sales in the 2nd
quarter of 2006 versus the fourth quarter of 2005.
Net cash used in investing activities for the six months ended June 30, 2006 was
$213,266, which was primarily used for the purchase of equipment.
Net cash used in financing activities for the six months ended June 30, 2006 was
$1,559,857 which primarily consisted of net repayments on our note payable to
bank of $1,553,667.
For the six months ended June 30, 2005 net cash used in operating activities was
$1,899,515. Net cash used in operations for the six months ended June 30, 2005
consisted of a net loss of $465,481 and included the following changes in
operating assets and liabilities: an increase in accounts receivable of
$710,925, and an increase in inventory of $1,317,230. These increases were the
result of increased sales volume.
Net cash used in investing activities for the six months ended June 30, 2005 was
$68,162, which was primarily used for the purchase of equipment.
Net cash provided by financing activities for the six months ended June 30, 2005
was $1,763,112 which primarily consisted of net proceeds on our note payable to
bank of $1,795,202.
The Company has entered into a financing agreement with Rosenthal & Rosenthal,
Inc. ("Rosenthal") dated November 11, 2004 and amended on November 1, 2005 (the
"Agreement"). Under the Agreement, Rosenthal may in its discretion lend to the
Company up to $10,000,000, which is the maximum credit under the facility, based
on eligible inventory and receivables. All borrowings are due on demand, are
secured by substantially all of the assets of the Company and are subject to the
Company's compliance with certain financial covenants. The Company's CEO and the
Company's President have signed limited guaranties in respect of borrowings
under the Agreement.
The amendment dated November 1, 2005 among other things increased the maximum
credit under the facility from $5,000,000 to $10,000,000 and reduced the
interest rate on borrowings by 0.5%.
The Agreement terminates November 30, 2007 unless terminated by Rosenthal on 30
days' notice. Interest accrues on outstanding borrowings at the prime rate (but
not less than 4.75%) plus 1.5%. At June 30, 2006, the interest rate on
borrowings outstanding was 9.75%. In addition, the Company will pay the lender
on each anniversary date an annual fee of 1% of the maximum credit which is
amortized over one year, and a monthly administrative fee of $1,000. The
financing expense for the annual fee recorded for the three months ended June
30, 2006 and 2005 amounted to approximately $25,000 and $12,500, respectively,
and for the six months ended June 30, 2006 and 2005 amounted to approximately
$50,000 and $25,000, respectively. At June 30, 2006 and December 31, 2005, the
principal amount outstanding under the facility was $3,581,500 and $5,135,167,
respectively.
In connection with establishing the Agreement, the Company issued to Rosenthal a
warrant (the "Warrant") to purchase 500,000 shares of common stock at $0.10 per
share. The Warrant expires on November 30, 2010. On notice by the Company the
Warrants will expire earlier if the closing price of the common stock during a
period designated in the Warrants is not less than $0.40 per share. The Warrants
may be exercised for cash or on a cashless basis (i.e., by deducting from the
number of shares otherwise issuable on exercise a number of shares that have a
then market value equal to the exercise price). The Company recorded a deferred
financing cost of approximately $60,000 in the fourth quarter 2004, representing
the fair value of the warrants, which will be amortized over the life of the
financing agreement of three years. The financing expense recorded for the three
months ended June 30, 2006 and 2005 amounted to approximately $5,000 and $4,500,
respectively, and for the six months ended June 30, 2006 and 2005 amounted to
approximately $10,000 and $9,000, respectively.
13
Under the terms of the Agreement, the Company is required to maintain a
specified level of net worth, working capital and debt ratios as defined. On
March 21, 2006, the Company and Rosenthal agreed to amend the covenants,
effective December 31, 2005. On August 9, 2006, the Company and Rosenthal agreed
to amend and increase the capital expenditures covenant, effective June 30,
2006. The Company was in compliance with all its covenants at June 30, 2006.
The Company believes that it will have sufficient liquidity for the next twelve
months and the foreseeable future. However, the Company would be materially and
adversely affected if Rosenthal demands payment of these borrowings under the
Agreement and the Company is unable to refinance these borrowings.
On June 8, 2006, the Company entered into an Agreement with Three Boroughs LLC
to lease approximately 25,000 square feet of space located at 1160 Commerce
Avenue, Bronx, New York, of which approximately 18,000 and 7,000 square feet
will be utilized for warehouse and office space, respectively. The lease has a
five-year term commencing on June 1, 2006 and expiring on May 31, 2011, unless
otherwise extended by the Company under an option to extend the term for an
additional five-year term expiring on May 31, 2016. The annual base rent is
$295,000 for the first year of the term (payable in 12 equal monthly payments of
approximately $24,583, with an abatement equal to approximately $24,583 for the
first rental payment) and increases 3.5% on June 1st of each year beginning with
June 1, 2007. In the event the Company exercises the option, the annual base
rent will continue to increase at the 3.5% annual rate.
On June 13, 2006, the Company as lessee entered into a lease agreement for
approximately 7,000 square feet of space located at 2310 NW 102 Place, Miami,
Florida, of which approximately 5,000 and 2,000 square feet will be used for
warehouse and showroom/office space, respectively. The lease has a five-year
term commencing on June 1, 2006. The annual base rent is $56,400 for the first
two years of the term (payable in monthly payments of $4,700), and increases
2.0% on June 1st of each year beginning with June 1, 2008. In addition, the
Company must pay condominium maintenance fees (currently $600 per month), real
property taxes (currently $800 per month) and all applicable sales tax.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk represents the risk of changes in value of a financial instrument,
derivative or non-derivative, caused by fluctuations in interest rates, foreign
exchange rates and equity prices. The Company has no financial instruments that
give it exposure to foreign exchange rates or equity prices.
The Company's pre-tax earnings and cash flows are exposed to changes in interest
rates as all borrowings under its credit facility bear interest at the prime
rate (but not less than 4.75%) plus 1.5%. As of June 30, 2006, the Company's
note payable-bank bore interest at 9.75%. As of June 30, 2006, a hypothetical
immediate 10% adverse change in prime interest rates relating to the Company's
note payable-bank would have an approximate $35,000 unfavorable impact on its
earnings and cash flows over a one-year period, assuming the borrowing level
remains consistent with the outstanding borrowings as of June 30, 2006. The fair
value of the borrowings under the credit facility is not affected by changes in
market interest rates.
ITEM 4. CONTROLS AND PROCEDURES
An evaluation has been carried out under the supervision and with the
participation of our management, including our Chief Executive Officer and Chief
Financial Officer/Principal Financial and Accounting Officer, of the
effectiveness of the design and the operation of our "disclosure controls and
procedures" (as such term is defined in Rules 13a-15(e) under the Securities
Exchange Act of 1934) as of June 30, 2006 ("Evaluation Date"). Based on such
evaluation, our Chief Executive Officer and Chief Financial Officer/Principal
Financial and Accounting Officer have concluded that, as of the Evaluation Date,
the disclosure controls and procedures are reasonably designed and effective to
ensure that (i) information required to be disclosed by us in the reports we
file or submit under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in the SEC's rules and
forms, and (ii) such information is accumulated and communicated to our
management, including our Chief Executive Officer and Chief Financial
Officer/Principal Financial and Accounting Officer, as appropriate to allow
timely decisions regarding required disclosure.
PART 2. OTHER INFORMATION
Item numbers 2, 3, 4 and 5 are not applicable and have been omitted.
ITEM 1. LEGAL PROCEEDINGS
On August 19, 2004 a complaint was filed by Radio Wave LLC ("Plaintiff"), in the
Supreme Court of the State of New York, County of New York, against the
predecessor entity, Essential Reality, Inc., Essential Reality, LLC and David
Devor, a former officer and a current employee of the Company, for rent and
costs relating to premises formerly occupied by the Company. Plaintiff seeks to
recover $150,416 for the period up to August 31, 2004, plus additional amounts
to be determined by the Court for the period subsequent to August 31, 2004.
Plaintiff also seeks to recover $50,000 in expenses and attorney fees plus
additional amounts to be determined by the Court. On June 27, 2006, the Court
dismissed a motion for summary judgment brought by Plaintiff. The Company is
currently in settlement discussions with the Plaintiff and has provided a
reserve for its estimate of the loss.
14
ITEM 1A. RISK FACTORS
We have a limited operating history and have engaged in our current business
only since August 2003.
In November 2003, under prior management of the Company, we discontinued our
business of manufacturing and selling a video controller. Our current videogame
distribution business commenced operations on August 11, 2003 and was acquired
by us in June 2004. We have not yet demonstrated our ability to operate
profitably during a major downturn in our industry.
We may be unable to sell our existing inventory after announcements by major
manufacturers of new platform launches.
We may be adversely affected if a current industry slowdown in consumer
purchases of hardware models continues for a lengthy period of time. Because of
the planned introduction of new system platforms from Sony Corporation,
Nintendo, and shortages in Xbox 360 consoles from Microsoft, consumers often
elect to wait for these new models instead of purchasing current systems, and
this can cause a significant slowdown in industry revenues. If this were to
continue and intensify, there would be a significant negative impact on our
customers' ability to sell their existing inventory. As a result, orders for
current systems would be reduced significantly, which would greatly limit our
ability to sell these products. Although major manufacturers have traditionally
reduced the prices of their current hardware models ahead of the launch of new
systems, we cannot assure you that these manufacturers will continue this price
reduction strategy. Even if manufacturers do reduce prices, we cannot assure you
that any past success will result in increased purchases of existing systems
ahead of new platform launches.
We are dependent on the contributions of our key executives and must maintain
their services; Not entitled to key man proceeds.
Our success depends in large degree upon the skills of our senior management
team and key employees and, in particular, Jay Gelman, our Chairman and CEO, and
Andre Muller, our COO. An employment agreement with Mr. Gelman expired on June
30, 2006. None of such persons has expressed any intention to terminate or not
commence services on our behalf, as the case may be. We have obtained only
$1,000,000 in key man insurance on the life of Mr. Gelman, and this policy has
been assigned to the Company's senior lender. The loss of the services of any of
these persons would have a material adverse effect on our business.
Gross margins relating to our business have been historically narrow which
increases the impact of variations in costs on our operating results.
As a result of intense price competition, our gross margins in our business have
historically been narrow and may continue to be narrow in the future.
Accordingly, slight variations in operating costs and expenses could result in
losses in our distribution business from period to period.
We depend on a limited number of suppliers and have no long-term agreement with
any suppliers.
Our ability to obtain particular products in required quantities and to fulfill
customer orders on a timely basis is critical to our success. In most cases, we
have no guaranteed price or delivery agreements with suppliers. In certain
product categories, limited price concessions or return rights offered by
publishers may have a bearing on the amount of product we may be willing to
purchase. Our industry may experience significant hardware supply shortages from
time to time due to the inability of certain manufacturers to supply certain
products on a timely basis. As a result, we have experienced, and may in the
future continue to experience, short-term hardware inventory shortages. In
addition, we do not develop or manufacture any of the products we sell, but act
solely as a distributor for the products of third parties. As such, we are
entirely dependent on manufacturers or publishers who currently distribute their
products through us, and who may, at any time, decide to distribute, or to
substantially increase their existing distribution, through other distributors,
or directly to retailers. During the six months ended June 30, 2006, our three
largest suppliers accounted for approximately 51.0% of our purchases (with one
accounting for approximately 27.8% of such total purchases alone) and our ten
largest suppliers in the aggregate accounted for approximately 76.8% of our
purchases. Our distribution agreements with our major suppliers are generally
terminable at any time by the suppliers on 30 days' prior written notice. In the
event that we are unable to maintain our distribution arrangements with one or
more of these significant suppliers, our business would be harmed and may not
survive.
We would be adversely affected by a change in the marketing and distribution of
videogame hardware systems and videogames by manufacturers.
Major manufacturers such as Sony, Nintendo and Microsoft, could change their
marketing strategies and rely less on their current distributors to sell
hardware systems and videogames. Since we depend on the products from these
manufacturers for a significant portion of our revenues, this would adversely
impact our financial situation, as there would be fewer products available for
sale by us and our customers would be forced to look for other sources to
procure the types of products we currently sell to them. Although we believe
that there is only a limited risk that these manufacturers would significantly
reduce their distribution of products through us, because of our high level of
product penetration and strong customer base, we cannot assure you that one or
more of these manufacturers will not take such action.
We have not entered into any distribution arrangement with Microsoft for
distribution of its Xbox(R) product.
To date we have no direct business relationship with Microsoft Corporation
("Microsoft") for the distribution of its Xbox(R) game console. The Xbox and
Xbox 360 consoles, currently represent an important segment of the videogame
console market. To date, as a result of our inability to obtain a direct
distribution arrangement with Microsoft for its Xbox products, we have had to
purchase Xbox(R) products from one of Microsoft's distributors, thereby reducing
our margins on these products. In the event that we are unable to acquire a
direct distribution arrangement with Microsoft, in the near future, for the sale
of Xbox products, including the newly-launched Xbox 360, our business could be
adversely affected.
15
Our quarterly operating results may vary significantly, which could cause the
price of our Common Stock to decline.
We have experienced and may continue to experience wide fluctuations in
quarterly operating results. The interactive entertainment industry is highly
seasonal, with sales typically higher during the fourth calendar quarter, due
primarily to the increased demand for games during the holiday buying season.
Our failure or inability to acquire products on a timely basis to meet seasonal
fluctuations in demand may harm our business and operating results. These
fluctuations could also cause the price of our Common Stock to decline. Other
factors that cause fluctuations include:
o delays in the introduction of new titles;
o the size and timing of product and business acquisitions;
o variations in sales of titles designed to operate on particular
platforms;
o availability of hardware platforms;
o product returns and price concessions; and
o the timing of orders from major customers.
Our expense levels are based, in part, on our expectations regarding future
sales and therefore our operating results would be harmed by a decrease in sales
or a failure to meet our sales expectations. The uncertainties associated with
interactive entertainment software development, manufacturing lead times,
production delays and the approval process for products by hardware
manufacturers and other licensors make it difficult to predict the quarter in
which products will ship and therefore may cause us to fail to meet financial
expectations. In future quarters our operating results may fall below the
expectations of securities analysts and investors. In this event, the market
price of our Common Stock could significantly decline.
We are subject to the risk that our inventory values may decline and protective
terms under supplier arrangements may not adequately cover the decline in
values.
The interactive entertainment software and hardware industry is characterized by
the introduction of new and enhanced generations of products and evolving
industry standards. These changes may cause inventory to decline substantially
in value or to become obsolete. We are also exposed to inventory risk in our
distribution business to the extent that supplier price concessions are not
available on all products or quantities and are subject to time restrictions. In
addition, suppliers may become insolvent and unable to fulfill price concession
obligations.
We have no long term agreements with any customer and we are dependent on a
limited number of customers.
We do not have long-term purchase and sale agreements with any of our customers,
and all of our sales to customers are made on a purchase order by purchase order
basis. Although we believe that our customer base currently consists of
approximately 2,600 retail stores located throughout the United States and
Canada, with a majority being in the New York metropolitan area and surrounding
tri-state region, during the six months ended June 30, 2006, our largest
customer accounted for 10.4% of our sales, our top five customers accounted for
34.1% of our sales, our top ten customers accounted for 53.2% of our sales and
our top 25 customers accounted for 69.2% of our sales. Since we have no
long-term commitments with any of the customers to continue to purchase products
from us, the loss of any of these customers could have a materially adverse
effect on our business.
16
We hold no patents or material proprietary technology.
We have no intellectual property other than a trademark for "Video Game
Alliance."
Unanticipated warranty costs could affect our ability to operate profitably.
We do not have any facilities for the repair or service of any products, and
generally reimburse our customers in full for returns. Although the majority of
our suppliers accept these returns from us, certain suppliers credit us with a
fixed allowance for returns and require that we assume the risk of excess
returns. We will be adversely affected if our returns for these suppliers exceed
their return allowances.
Risks Related To Our Industry
Our business operates in a highly competitive environment.
The intense competition that characterizes our industry is based primarily on
breadth, availability and quality of product lines; price; terms and conditions
of sale; credit terms and availability; speed and accuracy of delivery; and
effectiveness of sales and marketing programs. Our competitors include regional,
national and international distributors, as well as hardware manufacturers and
software publishers. There are several distributors in the United States that
have revenues and financial resources and company history substantially greater
than us. We are at a disadvantage to these companies and need to compete on the
basis of the services we provide to our customers. We may lose market share or
be forced in the future to reduce our prices in response to the actions of our
competitors, and thereby experience a reduction in our gross margins.
We may be adversely affected if the financial health of the U.S. retail industry
should deteriorate.
We are subject to broad economic factors that drive consumer spending and
maintain the health of the U.S. retail industry. These factors include, but are
not limited to, unemployment rates, consumer credit levels, consumer confidence,
and household discretionary income. If any of these or other economic factors
should erode, consumer spending would fall and the U.S. retail industry would
suffer a downturn. Consequently, our earnings would be adversely impacted by
lower sales.
We may be adversely affected by the trend towards retail trade consolidation.
As we pursue our retail distribution strategy, our sales will be contingent upon
the favorable wholesale prices that we can obtain from retailers. If retailers
merge or the retail industry consolidates, the larger, combined retailers will
have significant pricing power because of the sheer size of their retail
networks. As a result, we may not be able to obtain reasonable prices for the
products we distribute. Consequently, our margins will decline and our results
of operations would be reduced. There can be no assurance that we will be able
to obtain reasonable wholesale prices for the products we distribute under a
scenario where retailers merge and consolidate into larger entities.
The market for the titles we carry is characterized by short product life
cycles.
The market for the titles we carry is characterized by short product life cycles
and frequent introductions of new products. New products introduced may not
achieve significant market acceptance or achieve sufficient sales to permit us
to recover the amounts advanced by us to purchase such products, as well as our
marketing costs. The life cycle of a game generally involves a relatively high
level of sales during the first few months after introduction followed by a
decline in sales. Because revenues associated with the initial shipments of a
new product generally constitute a high percentage of the total revenues
associated with the life of a product, any delay in the introduction of one or
more new products or our ability to obtain such products on a timely basis,
could adversely affect our operating results for particular periods.
Our business is cyclical, and we may fail to anticipate changing consumer
preferences.
Our business is subject to all of the risks generally associated with the
interactive entertainment industry, which has been cyclical in nature and has
been characterized by periods of significant growth followed by rapid declines.
Our future operating results will depend on numerous factors beyond our control,
including:
o the popularity, price and timing of new software and hardware
platforms being released and distributed by us and our competitors;
o international, national and regional economic conditions,
particularly economic conditions adversely affecting discretionary
consumer spending;
o war, acts of terrorism and military action, which could adversely
affect consumer preferences in entertainment;
o changes in consumer demographics;
o the availability and popularity of other forms of entertainment; and
o critical reviews and public tastes and preferences, all of which
change rapidly and cannot be predicted.
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In order to plan for acquisition and promotional activities, we must anticipate
and respond to rapid changes in consumer tastes and preferences. A decline in
the popularity of interactive entertainment or particular platforms could cause
sales of the products we distribute to decline dramatically. The period of time
necessary to develop new game titles, obtain approvals of manufacturers and
produce finished products is unpredictable. During this period, consumer appeal
for a particular title may decrease, causing product sales to fall short of
expectations.
Rating systems for interactive entertainment software, potential legislation and
consumer opposition could inhibit sales of the products we carry.
Trade organizations within the videogame industry require interactive
entertainment software publishers to provide consumers with information relating
to graphic violence, profanity or sexually explicit material contained in
software titles, and impose penalties for noncompliance. We understand that
certain countries have also established similar rating systems as prerequisites
for sales of interactive entertainment software in such countries. Our
suppliers' software titles receive a rating of "E" (age 6 and older), "T" (age
13 and over) or "M" (age 17 and over). Many of the new titles we carry have
received an M rating. We do not know whether our supplies properly comply with
such rating systems or properly display the ratings and content descriptions
received for our titles.
Several proposals have been made for federal legislation to regulate the
interactive entertainment software, motion picture and recording industries,
including a proposal to adopt a common rating system for interactive
entertainment software, television and music containing violence or sexually
explicit material, and the Federal Trade Commission has issued reports with
respect to the marketing of such material to under-17 audiences. Consumer
advocacy groups have also opposed sales of interactive entertainment software
containing graphic violence or sexually explicit material by pressing for
legislation in these areas (including legislation prohibiting the sale of
certain "M" rated videogames to under-17 audiences) and by engaging in public
demonstrations and media campaigns. Retailers may decline to sell interactive
entertainment software containing graphic violence or sexually explicit
material, which may limit the potential market for the "M" rated products we
sell, and adversely affect our operating results. If any groups (including
international, national and local political and regulatory bodies) were to
target our suppliers' "M" rated titles, we might be required to discontinue a
particular title, which in the case of the best selling titles could seriously
hurt our business.
Our business is subject to sudden changes in the popularity of the products we
distribute and to technological changes.
We will be adversely affected by any material decrease in the attractiveness of
videogames, or by the availability of equivalent entertainment through the
Internet or other channels. The sudden decline in popularity of even one
particular video console or game can force us to make a substantial write-down
of our inventory of these products.
ITEM 6. EXHIBITS.
Exhibits.
EXHIBIT INDEX
NUMBER DESCRIPTION
--------- --------------------
10.1 Form of Amendment dated August 9, 2006 to the Financing Agreement
between the Company and Rosenthal & Rosenthal, filed herewith.
31.1 Certification of Chief Executive Officer pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
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SIGNATURES
In accordance with the requirements 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.
August 11, 2006
Alliance Distributors Holding Inc.
By: /s/ Jay Gelman
-------------------------------------------
Jay Gelman
CEO and Chairman of the Board
By: /s/ Barbara A. Ras
-------------------------------------------
Barbara A. Ras
Chief Financial Officer/Principal Financial and
Accounting Officer
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