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 September 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.
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(Exact name of registrant as specified in its charter)
Delaware 33-0851302
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1160 Commerce Avenue, Bronx, New York 11462
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(Address of principal executive offices) (Zip Code)
(718) 536-2248
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(Registrant's telephone number, including area code)
15-15 132nd Street, College Point, New York 11356
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(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 October, 31, 2006
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Common Stock, $.001 par value per share 48,721,065 shares
PART I. FINANCIAL INFORMATION Page No.
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Item 1-
Balance Sheets at September 30, 2006 and
December 31, 2005 2
Statements of Operations for the Three and Nine
Months Ended September 30, 2006 and 2005 3
Statement of Stockholders' Equity for the Nine
Months Ended September 30, 2006 4
Statements of Cash Flows for the Nine Months Ended
September 30, 2006 and 2005 5
Notes to Financial Statements 6
Item 2 Management's Discussion and Analysis of Financial Condition
and Results of Operations 11
Item 3 Quantitative and Qualitative Disclosures about Market Risk 17
Item 4 Controls and Procedures 17
PART II. OTHER INFORMATION
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Item 1 Legal Proceedings 18
Item 1A Risk Factors 18
Item 6 Exhibits 22
Signatures 23
ALLIANCE DISTRIBUTORS HOLDING INC.
BALANCE SHEETS
(In Thousands, except per share amounts)
September 30, December 31,
2006 2005
----------- -----------
Unaudited Derived from
audited
financial
statements
ASSETS
CURRENT ASSETS:
Cash and equivalents $ 258 $ 252
Accounts receivable-net 4,877 5,526
Inventory 6,029 5,369
Due from vendors 431 739
Prepaid acquisition and proposed offering costs -- 162
Prepaid expenses and other current assets 380 225
Deferred income taxes 323 155
----------- -----------
Total current assets 12,298 12,428
PROPERTY AND EQUIPMENT - NET 688 371
OTHER ASSETS 97 71
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TOTAL $ 13,083 $ 12,870
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LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Notes payable - bank $ 4,959 $ 5,135
Accounts payable 4,632 4,033
Current portion of long term obligations 13 19
Accrued expenses and other current liabilities 308 394
----------- -----------
Total current liabilities 9,912 9,581
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DEFERRED LEASE OBLIGATIONS 62 26
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LONG TERM OBLIGATIONS 6 12
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STOCKHOLDERS' EQUITY:
Series A Convertible Non-Redeemable Preferred Stock, $.001 par value; 8,530
and 8,615 shares authorized; 262 and 347 shares issued and
outstanding at September 30, 2006 and December 31, 2005, respectively -- --
Common stock, $.001 par value; 100,000 shares authorized; 48,721
and 47,369 shares issued and outstanding at September 30, 2006 and
December 31, 2005, respectively 49 47
Additional paid-in capital 3,379 3,225
Accumulated deficit (325) (21)
----------- -----------
Total stockholders' equity 3,103 3,251
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TOTAL $ 13,083 $ 12,870
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See notes to financial statements
2
ALLIANCE DISTRIBUTORS HOLDING INC.
STATEMENTS OF OPERATIONS
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
(In thousands, except per share amounts)
(Unaudited)
Three Months Nine Months
-------------------------- --------------------------
2006 2005 2006 2005
----------- ----------- ----------- -----------
NET SALES $ 15,453 $ 13,566 $ 42,040 $ 36,679
COST OF GOODS SOLD 14,093 12,035 37,470 32,835
----------- ----------- ----------- -----------
GROSS PROFIT 1,360 1,531 4,570 3,844
----------- ----------- ----------- -----------
OPERATING COSTS AND EXPENSES:
Selling and administrative expenses 1,654 1,187 4,267 3,739
Terminated transaction costs -- -- 257 --
----------- ----------- ----------- -----------
Total operating expenses 1,654 1,187 4,524 3,739
----------- ----------- ----------- -----------
(LOSS) INCOME FROM OPERATIONS (294) 344 46 105
Interest expense 177 119 551 340
----------- ----------- ----------- -----------
(LOSS) INCOME BEFORE (BENEFIT FROM)
PROVISION FOR INCOME TAXES (471) 225 (505) (235)
(Benefit from) provision for income taxes (188) 3 (201) 8
----------- ----------- ----------- -----------
NET (LOSS) INCOME $ (283) $ 222 $ (304) $ (243)
=========== =========== =========== ===========
Net loss per share - basic $ (.01) $ -- $ (.01) $ (.01)
=========== =========== =========== ===========
Net loss per share - diluted $ (.01) $ -- $ (.01) $ (.01)
=========== =========== =========== ===========
Weighted average common shares outstanding - basic 48,721 46,417 48,538 46,417
=========== =========== =========== ===========
Weighted average common shares outstanding - diluted 48,721 49,122 48,538 46,417
=========== =========== =========== ===========
See notes to financial statements
3
ALLIANCE DISTRIBUTORS HOLDING INC.
STATEMENT OF STOCKHOLDERS' EQUITY
NINE MONTHS ENDED SEPTEMBER 30, 2006
(In thousands)
(Unaudited)
Preferred Stock A Common Stock Additional Total
Shares Amount Shares Amount Paid in Accumulated Shareholders'
Capital Deficit Equity
----------- ----------- ----------- ----------- ----------- ----------- -----------
Balance, January 1, 2006 347 $ -- 47,369 $ 47 $ 3,225 $ (21) $ 3,251
Conversion of Preferred
Stock A into Common
Stock (85) -- 1,352 2 (2) --
Stock option
compensation expense 156 156
Net loss -- -- -- -- -- (304) (304)
----------- ----------- ----------- ----------- ----------- ----------- -----------
Balance, September 30, 2006 262 $ -- 48,721 $ 49 $ 3,379 $ (325) $ 3,103
=========== =========== =========== =========== =========== =========== ===========
See notes to financial statements
4
ALLIANCE DISTRIBUTORS HOLDING INC.
STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 2006 and 2005
(In thousands)
(Unaudited)
2006 2005
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OPERATING ACTIVITIES:
Net loss $ (304) $ (243)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Gain from insurance recovery (105) --
Deferred rent 36 7
Depreciation and amortization 94 84
Bad debt expense 56 100
Stock option compensation expense 156 34
Amortization of deferred financing costs 90 51
Deferred income taxes (168) --
Changes in operating assets and liabilities:
Accounts receivable 594 187
Inventory (660) (604)
Due from vendors 308 (324)
Prepaid acquisition and proposed offering costs 162 --
Prepaid expenses and other current assets (72) (51)
Accounts payable 598 487
Accrued expenses and other current liabilities (84) 39
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Net cash provided by (used in) operating activities 701 (233)
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INVESTING ACTIVITIES:
Purchase of property and equipment (590) (77)
Proceeds from insurance claim 124 --
Increase in other assets (41) (12)
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Net cash used in investing activities (507) (89)
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FINANCING ACTIVITIES:
Proceeds from note payable - bank 41,514 36,369
Repayments of note payable - bank (41,691) (36,132)
Payments for registration and issuance costs -- (16)
Payment of long-term obligations (11) (22)
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Net cash (used in) provided by financing activities (188) 199
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INCREASE (DECREASE) IN CASH AND EQUIVALENTS 6 (123)
CASH AND EQUIVALENTS, BEGINNING OF PERIOD 252 221
------------- -------------
CASH AND EQUIVALENTS, END OF PERIOD $ 258 $ 98
============= =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest $ 484 $ 289
============= =============
Income taxes $ 100 $ 7
============= =============
See notes to financial statements
5
ALLIANCE DISTRIBUTORS HOLDING INC.
Notes to Unaudited Financial Statements
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 September 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
September 30, 2006 and December 31, 2005, the Company's allowance for doubtful
accounts totaled approximately $236,000 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 certain of 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 September 30, 2006 and December 31, 2005.
6
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 carry forwards 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.
The denominator for diluted net income per share for the three months ended
September 30, 2005 includes 262,000 and 2,443,000 shares issuable upon
conversion of warrants and Series A Convertible Non-Redeemable Preferred Stock,
respectively.
Common equivalents for the three and nine months ended September 30, 2006
exclude 1,969,000 for common shares issuable upon exercise of warrants and
2,101,000 common shares issuable upon conversion of Series A Convertible
Non-Redeemable Preferred Stock since their effect would be anti-dilutive. Common
equivalents for the nine months ended September 30, 2005 exclude 500,000 for
common shares issuable upon exercise of warrants and 403,000 for common shares
issuable upon conversion of Series A Convertible Non-Redeemable Preferred Stock
since their effect would be anti-dilutive.
Stock Based Compensation
Pursuant to Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees," ("APB 25") prior to January 1, 2006 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 options granted to employees, since the options were
granted at or above market value.
Effective January 1, 2006, the Company adopted Statement of Financial Accounting
Standards No. 123(R), "Share Based Payment" ("SFAS No. 123(R)") 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. 123(R) for all share-based payments granted after that date and for all
unvested awards granted prior to that date.
7
The following table illustrates the effect on net income (loss) and income
(loss) per share for the three and nine months ended September 30, 2005 (in
thousands, except per share amounts) if the Company had applied the fair value
recognition provisions of SFAS No. 123(R) to stock-based employee compensation.
Three months Nine months
ended September ended September
30, 2005 30, 2005
------------ ------------
Net income (loss) as reported $ 222 $ (243)
Deduct: Total stock-based employee
compensation determined under fair value
based method, net of related tax effects (53) (161)
------------ ------------
Pro forma net income (loss) $ 169 $ (404)
============ ============
Income (loss) per share:
Basic - as reported $ 0.00 $ (0.01)
============ ============
Basic - pro forma $ 0.00 $ (0.01)
============ ============
Diluted - as reported $ 0.00 $ (0.01)
============ ============
Diluted - pro forma $ 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 nine months ended
September 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 nine months
ended September 30, 2006.
Recent Accounting Pronouncements
In July 2006, the FASB issued FASB Interpretation No. 48 (FIN 48) "Accounting
for Uncertainty in Income Taxes" which prescribes a recognition threshold and
measurement process for recording in the financial statements uncertain tax
positions taken or expected to be taken in a tax return. Furthermore, FIN 48
provides guidance on the recognition, classification, accounting in interim
periods and disclosure requirements for uncertain tax positions. The accounting
provisions of FIN 48 are effective for fiscal years beginning after December 15,
2006. The Company is in the process of determining the effect of FIN 48, if any,
on its financial statements.
In September 2006, the Securities and Exchange Commission ("SEC") issued Staff
Accounting Bulletin No. 108 (SAB 108) "Considering the Effects of Prior Year
Misstatements in Current Year Financial Statements." SAB 108 provides guidance
on quantifying financial statement misstatements, including the effects of prior
year errors on current year financial statements. SAB 108 is effective for
periods ending after November 15, 2006. The Company is in the process of
determining the effect of SAB 108 if any, on its financial statements.
In September 2006, the FASB issued SFAS No. 157 "Fair Value Measures" ("SFAS
157"). SFAS 157 defines fair value, establishes a framework for measuring fair
value, and expands disclosures about fair value measurements. This statement
applies under other accounting pronouncements that require or permit fair value
measurements, however it does not apply to SFAS 123R. This Statement shall be
effective for financial statements issued for fiscal years beginning after
November 15, 2007, and interim periods within those fiscal years. Earlier
application is encouraged, provided that the reporting entity has not yet issued
financial statements for that fiscal year, including any financial statements
for an interim period within that fiscal year. The provisions of this statement
should be applied prospectively as of the beginning of the fiscal year in which
this Statement is initially applied, except in some circumstances where the
statement shall be applied retrospectively. The Company is currently evaluating
the effect, if any, of SFAS 157 on its financial statements.
Note 3 - FINANCING AGREEMENT
The Company has 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.
8
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 earlier 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 September 30, 2006, the
interest rate on borrowings outstanding was 9.75%. In addition, the Company is
obligated to 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 totaled
approximately $25,000 and $12,500 for the three months ended September 30, 2006
and 2005, respectively, and approximately $75,000 and $50,000 for the nine
months ended September 30, 2006 and 2005, 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 by Rosenthal at $.10 per share 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 is
amortized over the life of the financing agreement of three years. The financing
expense recorded for the three months ended September 30, 2006 and 2005 totaled
approximately $5,000 and $4,500, respectively, and for the nine months ended
September 30, 2006 and 2005 amounted to approximately $15,000 and $13,500,
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 September 30,
2006. As of September, 30, 2006, the Company did not comply with certain
financial covenants for which Rosenthal has provided a waiver.
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 if the Company is unable to refinance these borrowings.
Note 4 - LITIGATION
In October 2006, the Company paid $200,000 in settlement of a legal proceeding
that had been brought against Essential Reality, Inc. (a predecessor of the
Company), 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. As of December 31, 2005, the Company had accrued
$125,000 against the potential outcome of the litigation. For the nine months
ended September 30, 2006, the Company accrued an additional $75,000, resulting
in an aggregate liability of $200,000 accrued at September 30, 2006.
Note 5 - TERMINATED TRANSACTION COSTS
On April 26, 2006, the Company announced that it would not acquire Foto Electric
Supply Co., Inc. (Fesco). An agreement by the Company to acquire Fesco had
expired by its terms on February 28, 2006, and subsequent discussions to extend
and amend the agreement ended. As a result, the Company recorded a charge of
approximately $257,000 in the first quarter of 2006 for its costs in the
terminated transaction.
Note 6 - COMMITMENTS
On June 8, 2006, the Company entered into an agreement to lease approximately
25,000 square feet of space located in New York City, 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.
9
On June 13, 2006, the Company entered into a lease agreement for approximately
7,000 square feet of space located in 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 is obligated to pay
condominium maintenance fees (currently $600 per month), real property taxes
(currently $800 per month) and all applicable sales tax.
In October 2006, the Company entered into a two year employment agreement with
its Chief Financial Officer (the "Officer"). The agreement provides for annual
base compensation of $210,000 per annum as well as for insurance and other
fringe benefits, and contains confidentiality and non-compete and
non-interference provisions. The Company may terminate the employment under the
agreement without cause (as defined) at any time, provided that, in such case,
the Company will, as severance, continue to pay an amount equal to his then base
salary in normal payroll installments, subject to withholding, for six months or
if less until September 30, 2008. In addition, the Company will pay the cost of
COBRA for the period during which severance is payable as aforesaid. In
addition, the Company granted an option effective on October 3, 2006 to purchase
100,000 shares of the Company's common stock under the Company's stock option
plan at an exercise price of $0.18 per share. The option has a 10 year term, and
vests in 12 equal installments on the last day of each of the 12 calendar
quarters beginning with the calendar quarter that begins on October 1, 2006, but
only so long as the Officer is employed by the Company on the last day of such
calendar quarter.
10
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 our accounting policies require the application of significant
judgment by us 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 - We recognize sales upon shipment of products to customers
as title and risk of loss pass upon shipment and collectibility is reasonably
assured. We provide provisions for estimated uncollectible discounts and rebates
to customers, estimated returns and allowances and other adjustments in the same
period the related sales are recorded. While such amounts have been within
expectations and the provisions established, we cannot guarantee that we 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. We establish credit terms for new
clients based upon a review of their credit information and perform ongoing
credit evaluations of our customers, adjusting credit terms when we believe
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. We determine 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
us, 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, we cannot guarantee that credit loss rates in the future will be
consistent with those experienced in the past. In addition, we have credit
exposure if the financial condition of one of our 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 our
estimate of the allowance for doubtful accounts will change. As of September 30,
2006 and December 31, 2005, our allowance for doubtful accounts approximated
$236,000 and $181,000, respectively.
Inventories - Inventory is stated at the lower of cost or market, cost being
determined on the average cost basis. We receive price protection from certain
of our suppliers for merchandise that may be slow moving or aged. We evaluate
the adequacy of our slow moving or aged inventory quarterly and write down
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, we cannot guarantee that we will continue to experience the same
level of write-downs as in the past. We do not offer warranties to our customers
but will accept returns of product claimed to be defective and reimburse the
customers for the full purchase price. The majority of our suppliers in turn
accept these returns from us. There are no reserves for warranties as of
September 30, 2006 and December 31, 2005.
11
Income Taxes - At December 31, 2005, we had federal and state net operating loss
carryforwards (NOL's) of approximately $5.5 million. In accordance with SFAS No.
109, "Accounting for Income Taxes", we establish valuation allowances if it is
"more likely than not" that we will not be able to utilize the NOLs to offset
future taxes. We have established a valuation allowance for the full amount of
the December 31, 2005 NOL 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 us (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. We have 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.
12
RESULTS OF OPERATIONS
Three Months Ended September 30, 2006 compared to Three Months Ended September
30, 2005:
The following table shows each specified item as a dollar amount (in thousands)
and as a percentage of net sales for the three months ended September 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 ended September 30,
-------------------------------
2006 2005
---------------------------- ---------------------------
Net sales $ 15,453 100.0% $ 13,566 100.0%
Cost of goods sold 14,093 91.2% 12,035 88.7%
------------ ------------ ------------ ------------
Gross profit 1,360 8.8% 1,531 11.3%
Selling and administrative expenses 1,654 10.7% 1,187 8.7%
------------ ------------ ------------ ------------
(Loss) income from operations (294) (1.9%) 344 2.5%
Interest expense 177 1.1% 119 0.9%
------------ ------------ ------------ ------------
(Loss) income before (benefit from) provision for income taxes (471) (3.0%) 225 1.7%
(Benefit from) provision for income taxes (188) (1.2%) 3 --
------------ ------------ ------------ ------------
Net (loss) income $ (283) (1.8%) $ 222 1.6%
============ ============ ============ ============
Net sales increased by $1,887,000, or 14%, from $13,566,000 for the three months
ended September 30, 2005 to $15,453,000 for the three months ended September 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 $2,058,000, or 17%, from $12,035,000 for the
three months ended September 30, 2005 to $14,093,000 for the three months ended
September 30, 2006. The increase is principally attributable to the increase in
net sales. Gross profit as a percentage of net sales decreased to 8.8% for the
three months ended September 30, 2006 from 11.3% for the three months ended
September 30, 2005. This decrease in gross margin reflects higher discounts
provided to customers as an inducement to increase volume. 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. Distribution costs were approximately $342,000 and $288,000 for
the three months ended September 30, 2006 and 2005, respectively.
Selling and administrative expenses increased by $467,000, or 39%, from
$1,187,000 for the three months ended September 30, 2005 to $1,654,000 for the
three months ended September 30, 2006. The increase was primarily the result of
approximately $104,000 in increased rent and utilities attributable to new
warehouse and showroom facilities in New York and Florida, approximately
$100,000 for increased payroll, commissions and related payroll costs,
approximately $100,000 expensed this period for a $200,000 settlement of a legal
proceeding (see Part II, Item 1), and approximately $41,000 related to
equity-based compensation resulting from the adoption of SFAS 123(R). The
remaining increase is attributable to various general increases in selling and
administrative expenses. Selling and administrative expenses as a percentage of
net sales increased to 10.7% for the three months ended September 30, 2006 from
8.7% for the three months ended September 30, 2005. For the three months ended
September 30, 2006, selling and administrative expenses were comprised of the
following: $192,000 in selling expenses, $342,000 in distribution costs and
$1,120,000 in administrative expenses. For the three months ended September 30,
2005, selling and administrative expenses were comprised of the following:
$172,000 in selling expenses, $288,000 in distribution costs and $727,000 in
administrative expenses.
13
Interest expense increased by $58,000, or 49%, from $119,000 for the three
months ended September 30, 2005 to $177,000 for the three months ended September
30, 2006. The increase was primarily due to higher interest rates on bank
borrowings and increased borrowings. The increased borrowing levels were the
result of increased sales volume that required higher inventory levels and
increased accounts receivable.
14
Nine Months Ended September 30, 2006 compared to Nine Months Ended September 30,
2005
The following table shows each specified item as a dollar amount (in thousands)
and as a percentage of net sales for the nine months ended September 30, 2006
and 2005, and should be read in conjunction with the financial statements
included elsewhere in this Quarterly Report on Form 10-Q:
Nine Months ended September 30,
-------------------------------
2006 2005
---------------------------- ----------------------------
Net sales $ 42,040 100.0% $ 36,679 100.0%
Cost of goods sold 37,470 89.1% 32,835 89.5%
------------ ------------ ------------ ------------
Gross profit 4,570 10.9% 3,844 10.5%
------------ ------------ ------------ ------------
Operating costs and expenses:
Selling and administrative expenses 4,267 10.1% 3,739 10.2%
Terminated transaction costs 257 0.7% -- --
------------ ------------ ------------ ------------
Total operating expenses 4,524 10.8% 3,739 10.2%
------------ ------------ ------------ ------------
Income from operations 46 0.1% 105 0.3%
Interest expense 551 1.3% 340 0.9%
------------ ------------ ------------ ------------
Loss before (benefit from) provision for income taxes (505) (1.2%) (235) (0.6%)
(Benefit from) provision for income taxes (201) (0.5%) 8 --
------------ ------------ ------------ ------------
Net loss $ (304) (0.7%) $ (243) (0.6%)
============ ============ ============ ============
Net sales increased by $5,361,000 or 15% from $36,679,000 for the nine months
ended September 30, 2005 to $42,040,000 for the nine months ended September 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 $4,635,000 or 14%, from $32,835,000 for the nine
months ended September 30, 2005 to $37,470,000 for the nine months ended
September 30, 2006. The increase was consistent with revenue growth. Gross
profit as a percentage of net sales increased slightly to 10.9% for the nine
months ended September 30, 2006 from 10.5% for the nine months ended September
30, 2005. 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
approximately $996,000 and $804,000 for the nine months ended September 30, 2006
and 2005, respectively.
Selling and administrative expenses increased by $528,000 or 14%, from
$3,739,000 for the nine months ended September 30, 2005 to $4,267,000 for the
nine months ended September 30, 2006. The increase was primarily the result of
increases in freight out expenses of approximately $171,000, due primarily to
fuel increases, approximately $190,000 for increased payroll, commissions and
related payroll costs, costs, approximately $121,000 related to equity-based
compensation resulting from the adoption of SFAS 123(R), approximately $134,000
in increased rent and utilities attributable to new warehouse and showroom
facilities in New York and Florida and the settlement of a legal proceeding.
These increases were in part offset by a decrease in professional fees of
$113,000 consisting primarily of decreased accounting and legal fees related to
Company SEC filings and a $105,000 gain from insurance proceeds for replacement
value of assets in excess of book value that were damaged a result of a fire
near our former 132nd Street location. Selling, general and administrative
expenses as a percentage of net sales decreased slightly to 10.1% for the three
months ended September 30, 2006 from 10.2% for the nine months ended September
30, 2005. For the three months ended September 30, 2006, selling and
administrative expenses were comprised of the following: $588,000 in selling
expenses, $996,000 in distribution costs and $2,683,000 in administrative
expenses. For the nine months ended September 30, 2005, selling and
administrative expenses were comprised of the following: $543,000 in selling
expenses, $804,000 in distribution costs and $2,392,000 in administrative
expenses.
15
We expensed terminated transaction costs of $257,000, or 1.0% of sales, in the
first quarter of 2006 as a result of our decision not to acquire Foto Electric
Supply Co., Inc. An agreement by the Company to acquire Fesco had expired by its
terms on February 28, 2006, and subsequent discussions to extend and amend the
agreement ended.
Interest expense increased by $211,000, or 62%, from $340,000 for the nine
months ended September 30, 2005 to $551,000 for the nine months ended September
30, 2006. The increase was primarily due to higher interest rates on bank
borrowings and increased borrowings. 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 nine months ended September 30, 2006 net cash provided by operating
activities was approximately $701,000. Net cash provided by operations for the
nine months ended September 30, 2006 consisted of a net loss of approximately
$304,000, offset by net changes in operating assets and liabilities totaling
approximately $846,000 and non-cash charges, net of non-cash credits for
deferred income taxes and an insurance recovery gain, approximating $159,000.
For the nine months ended September 30, 2005,we used net cash in operating
activities of approximately $233,000, which principally consisted of a net loss
of approximately $243,000 and net changes in operating assets and liabilities
totaling approximately $266,000, offset by non-cash charges approximating
$276,000.
For the nine months ended September 30, 2006, we used $507,000 cash for
investing activities compared to $89,000 cash used for investing activities in
the comparable period in 2005. For the nine months ended September 30, 2006 we
purchased $590,000 of property and equipment, of which approximately $500,000
was in connection with our move to a new warehouse, showroom and executive
offices in New York City, and approximately $20,000 was for our new warehouse in
Florida, which we opened in September 2006. Cash used in investing activities
for the nine months ended September 30, 2006 was in part offset by insurance
proceeds for replacement value of assets in excess of book value that were
damaged a result of a fire near our former 132nd Street location totaling
approximately $124,000.
Net cash used in financing activities for the nine months ended September 30,
2006 was approximately $188,000 which primarily consisted of net repayments on
our note payable to bank approximating $177,000. For the nine months ended
September 30, 2005, net proceeds on our note payable to bank approximated
$237,000.
We have a financing agreement (the "Agreement") with Rosenthal & Rosenthal, Inc.
("Rosenthal") pursuant to which Rosenthal may in its discretion lend to us 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 our assets, and require us to be in compliance with certain
financial covenants. Our CEO and our President have signed limited guaranties in
respect of borrowings under the Agreement.
The Agreement terminates November 30, 2007 unless earlier 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 September 30, 2006, the
interest rate on borrowings outstanding was 9.75%. In addition, we are obligated
to 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 totaled approximately
$25,000 and $12,500 for the three months ended September 30, 2006 and 2005,
respectively, and approximately $75,000 and $50,000 for the nine months ended
September 30, 2006 and 2005, respectively. At September 30, 2006 and December
31, 2005, we borrowed $4,959,000 and $5,135,000, respectively, under the
facility.
In connection with establishing the Agreement, we 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 by Rosenthal at $.10 per share 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). We
recorded a deferred financing cost of approximately $60,000 in the fourth
quarter 2004, representing the fair value of the warrants, which is amortized
over the life of the financing agreement of three years. The financing expense
recorded for the three months ended September 30, 2006 and 2005 totaled
approximately $5,000 and $4,500, respectively, and for the nine months ended
September 30, 2006 and 2005 amounted to approximately $15,000 and $13,500,
respectively.
16
Under the terms of the Agreement, we are required to maintain a specified level
of net worth, working capital and debt ratios as defined. On March 21, 2006, we
agreed with Rosenthal to amend the covenants, effective December 31, 2005. On
August 9, 2006, Rosenthal further agreed to amend and increase the capital
expenditures covenant, effective September 30, 2006. As of September, 30, 2006,
we did not comply with certain financial covenants for which Rosenthal has
provided a waiver.
We believe we will have sufficient liquidity for the next twelve months and the
foreseeable future. However, our business would be materially and adversely
affected if Rosenthal demands payment of these borrowings under the Agreement
and if we are unable to refinance these borrowings.
In September 2006, we relocated our offices, wholesale showroom, and warehouse
to a 25,000 square foot facility located at 1160 Commerce Avenue in the Bronx,
New York. The new facility, which provides almost 10,000 square feet more than
our old facilities, is leased for a five year term with an option for us to
extend the term for an additional 5 year term expiring on May 31, 2016. Annual
base rent is $295,000 for the first year of the term, with scheduled 3.5%
increases each year commencing on June 1, 2007.
In addition, in September 2006 we opened a 7,000 square feet distribution
facility and wholesale showroom in Miami, Florida.
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. We have no financial instruments that give us
exposure to foreign exchange rates or equity prices.
Our 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 September 30, 2006, our note payable-bank
bore interest at 9.75%. As of September 30, 2006, a hypothetical immediate 10%
adverse change in prime interest rates relating to the note would have an
approximate $48,000 unfavorable impact on our earnings and cash flows over a
one-year period, assuming the borrowing level remains consistent with the
outstanding borrowings as of September 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, 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 September 30, 2006 ("Evaluation
Date"). Based on such evaluation, our Chief Executive Officer and Chief
Financial 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, as
appropriate to allow timely decisions regarding required disclosure.
17
PART 2. OTHER INFORMATION
Item numbers 2, 3, 4 and 5 are not applicable and have been omitted.
ITEM 1. LEGAL PROCEEDINGS
In October 2006, the Company paid $200,000 in settlement of a legal proceeding
that had been brought against Essential Reality, Inc. (a predecessor of the
Company), 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. As of December 31, 2005, the Company had accrued
$125,000 against the potential outcome of the litigation. For the nine months
ended September 30, 2006, the Company accrued an additional $75,000, resulting
in an aggregate liability of $200,000 accrued at September 30, 2006.
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.
18
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 nine months ended September
30, 2006, our three largest suppliers accounted for approximately 49% of our
purchases (with one accounting for approximately 30% of such total purchases
alone) and our ten largest suppliers in the aggregate accounted for
approximately 75% 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.
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.
19
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 nine months ended September 30, 2006, our largest
customer accounted for 9% of our total sales, our top five customers accounted
for 36% of our sales, our top ten customers accounted for 52% of our sales and
our top 25 customers accounted for 68% 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.
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.
20
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.
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.
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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. (a) Exhibits.
31.1 Certificate of Chief Executive Officer pursuant to Section
302 of the Sarbanes Oxley Act of 2002.
31.2 Certificate of Chief Financial Officer pursuant to Section
302 of the Sarbanes Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as adopted
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.
November 14, 2006
Alliance Distributors Holding Inc.
By: /s/ Jay Gelman
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Jay Gelman
CEO and Chairman of the Board
By: /s/ Stephen Agress
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Stephen Agress
Executive Vice President and Chief Financial Officer
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