-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, CaNw7v8Vr7ee2cgyCyAh6nifvQpUXQJozp/De41SUNiZlSPG8NmdCKosDTyrv0e2 SlSjtZFGoRvUCUuqxbBVbw== 0000898430-01-500628.txt : 20010516 0000898430-01-500628.hdr.sgml : 20010516 ACCESSION NUMBER: 0000898430-01-500628 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20010331 FILED AS OF DATE: 20010515 FILER: COMPANY DATA: COMPANY CONFORMED NAME: LEARNINGSTAR CORP CENTRAL INDEX KEY: 0001130950 STANDARD INDUSTRIAL CLASSIFICATION: RETAIL-CATALOG & MAIL-ORDER HOUSES [5961] IRS NUMBER: 770559897 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-32613 FILM NUMBER: 1640116 BUSINESS ADDRESS: STREET 1: 2 LOWER RAGSDALE DRIVE, SUITE 200 CITY: MONTEREY STATE: CA ZIP: 93940 BUSINESS PHONE: 8313332000 MAIL ADDRESS: STREET 1: 2 LOWER RAGSDALE DRIVE, SUITE 200 CITY: MONTEREY STATE: CA ZIP: 93940 FORMER COMPANY: FORMER CONFORMED NAME: LEARNINGSTAR INC DATE OF NAME CHANGE: 20001229 10-Q 1 d10q.txt QUARTERLY REPORT FOR PERIOD ENDED 03/31/2001 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 March 31, 2001 [_] 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 0-32613 LEARNINGSTAR CORP. (Exact Name of Registrant as Specified in Its Charter) DELAWARE 77-0559897 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 2 Lower Ragsdale Drive, Suite 200 93940 Monterey, CA (Zip Code) (Address of Principal Executive Offices) Registrant's telephone number, including area code: (831) 333-2000 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 report(s), and (2) has been subject to such filing requirements for the past 90 days. 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: Common Stock, $.01 par value, 8,333,214 shares outstanding as of May 11, 2001. LEARNINGSTAR CORP. TABLE OF CONTENTS PART I: FINANCIAL INFORMATION................................................................... 3 ITEM 1. FINANCIAL STATEMENTS................................................................... 3 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.. 10 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK............................ 14 PART II: OTHER INFORMATION...................................................................... 14 ITEM 1. LEGAL PROCEEDINGS...................................................................... 14 ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.............................................. 14 ITEM 3. DEFAULTS UPON SENIOR SECURITIES........................................................ 14 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.................................... 14 ITEM 5. OTHER INFORMATION...................................................................... 15 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K....................................................... 24 SIGNATURE...................................................................................... 25
PART I: FINANCIAL INFORMATION LearningStar Corp. ("LearningStar") was incorporated in the State of Delaware on November 6, 2000 for the purpose of effecting the combination of the businesses of Earlychildhood LLC, a California limited liability company ("Earlychildhood") and SmarterKids.com, Inc., a Delaware corporation ("SmarterKids.com"). As of March 31, 2001, LearningStar was nominally capitalized and its balance sheet was comprised solely of common stock subscriptions receivable of $10.00 and common stock of $10.00 representing 1,000 shares of outstanding common stock at a par value of $0.01 per share. Accordingly, LearningStar's financial statements are not included in this Quarterly Report on Form 10-Q. The combination of Earlychildhood and SmarterKids.com (the "Combination") was completed on April 30, 2001 and, in connection therewith, each of Earlychildhood and SmarterKids.com became a wholly-owned subsidiary of LearningStar. As a result of the Combination, the former holders of outstanding membership interests in Earlychildhood and options to purchase membership interests in Earlychildhood own approximately two-thirds of the capital stock of LearningStar and the former holders of outstanding common stock of SmarterKids.com and options and warrants to purchase shares of common stock of SmarterKids.com own approximately one-third of the capital stock of LearningStar. As the former Earlychildhood members have a controlling interest in LearningStar following the Combination, the transaction has been recorded for accounting purposes as if Earlychildhood acquired SmarterKids.com, with Earlychildhood deemed to be the predecessor of LearningStar. Accordingly, pursuant to Rules 3-01 through 3-04 of Regulation S-X, Earlychildhood's unaudited consolidated financial statements are included in Item 1 herein. Given the nature of the Combination and since SmarterKids.com constitutes a significant acquisition to Earlychildhood, the corresponding financial statements of SmarterKids.com for the three months ended March 31, 2001 and 2000 are included herein in Item 5. ITEM 1. FINANCIAL STATEMENTS EARLYCHILDHOOD LLC CONSOLIDATED BALANCE SHEETS (In thousands) (Unaudited)
March 31, December 31, --------- ------------ 2001 2000 --------- ------------ ASSETS Current assets: Cash and cash equivalents .............................................................. $ 107 $ 181 Accounts receivable, net................................................................. 4,774 5,106 Inventories ............................................................................ 24,632 16,929 Prepaid expenses and other current assets ............................................. 1,837 2,051 ------- ------- Total current assets ................................................................. 31,350 24,267 Receivable from member ..................................................................... 139 139 Property and equipment, net ................................................................ 4,835 4,690 Other assets................................................................................. 2,044 1,975 Goodwill and other intangible assets, net.................................................... 6,823 7,071 ------- ------- Total assets ......................................................................... $45,191 $38,142 ======= ======= LIABILITIES AND MEMBERS' EQUITY Current liabilities: Bank overdraft ......................................................................... $ 476 $ 1,154 Short-term debt ........................................................................ 14,750 5,188 Accounts payable ....................................................................... 10,354 3,555 Accrued expenses ....................................................................... 2,779 1,860 Income tax related liabilities ......................................................... 12 422 Other current liabilities................................................................ 431 211 ------- ------- Total current liabilities ............................................................ 28,802 12,390 Deferred income taxes ...................................................................... 46 66 Notes payable.............................................................................. - 7,250 ------- ------- Total liabilities .................................................................... 28,848 19,706 ------- ------- Members' equity ............................................................................ 18,782 21,013 Deferred compensation ...................................................................... (2,439) (2,577) ------- ------- Total members' equity ..................................................................... 16,343 18,436 ------- ------- Total liabilities and members' equity ..................................................... $45,191 $38,142 ======= =======
See accompanying notes to consolidated financial statements. 3 EARLYCHILDHOOD LLC CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands) (Unaudited)
Three Months Ended March 31, -------------------------------- 2001 2000 --------------- ------------ Revenues.............................................................. $ 13,929 $ 12,503 Cost of goods sold.................................................... 8,331 7,926 ---------- ---------- Gross profit.......................................................... 5,598 4,577 ---------- ---------- Operating expenses: Selling, general and administrative (includes equity-based compensation of $138 for the three months ended March 31, 2001)................................................. 7,598 6,447 Amortization of goodwill and other intangible assets.............. 317 282 ---------- ---------- 7,915 6,729 ---------- ---------- Operating loss............................................. (2,317) (2,152) ---------- ---------- Other (income) expense: Interest expense.................................................. 292 317 Interest income................................................... (2) (15) ---------- ---------- 290 302 ---------- ---------- Income (loss) before income taxes.............................. (2,607) (2,454) Income tax benefit.................................................... 376 513 ---------- ---------- Net loss.......................................................... $ (2,231) $ (1,941) ========== ========== Pro forma income tax benefit.......................................... $ (924) $ (864) ========== ========== Pro forma net loss.................................................... $ (1,679) $ (1,590) ========== ========== Pro forma net loss per share - basic and diluted...................... $ (0.30) $ (0.29) ========== ========== Shares used in pro forma per share calculation - basic and diluted.... 5,605,269 5,576,067 ========== ==========
See accompanying notes to consolidated financial statements. 4 EARLYCHILDHOOD LLC CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited)
Three Months Ended March 31, -------------------------- 2001 2000 ------- ------- Cash flows from operating activities: Net loss................................................................................ $(2,231) $(1,941) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization......................................................... 657 438 Equity-based compensation............................................................. 138 -- Deferred income taxes................................................................. (376) (720) Changes in operating assets and liabilities: Accounts receivable............................................................. 332 434 Inventories..................................................................... (7,703) (8,506) Prepaid expenses and other current assets....................................... 214 (902) Other assets................................................................... (90) 1,068 Accounts payable................................................................ 6,799 7,289 Accrued expenses................................................................ 919 (316) Income tax related liabilities.................................................. (100) (521) Other current liabilities....................................................... 219 (93) ------- ------- Net cash used in operating activities..................................................... (1,222) (3,770) ------- ------- Cash flows from investing activities: Purchase of plant and equipment.................................................... (487) (1,723) Purchase of other intangible assets................................................ -- (209) ------- ------- Net cash used in investing activities..................................................... (487) (1,932) ------- ------- Cash flows from financing activities: Bank overdraft..................................................................... (678) -- Borrowings on line of credit....................................................... 2,313 4,000 Principal payments on line of credit............................................... -- (268) Issuance of membership interests, net of fees...................................... -- 2,000 ------- ------- Net cash provided by financing activities................................................. 1,635 5,732 ------- ------- Net (decrease) in cash and cash equivalents............................................... (74) 30 Cash and cash equivalents at beginning of period.......................................... 181 151 ------- ------- Cash and cash equivalents at end of period................................................ $ 107 $ 181 ======= ======= Supplemental disclosures of cash flow information: Cash payments during the period: Cash paid for interest............................................................. 292 318 Cash paid for taxes................................................................ 414 521
See accompanying notes to consolidated financial statements. 5 EARLYCHILDHOOD LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (amounts in thousands, except share and per share amounts) (Unaudited) 1. Basis of Presentation LearningStar Corp. ("LearningStar") was incorporated in the State of Delaware on November 6, 2000 for the purpose of effecting the combination of the businesses of Earlychildhood LLC, a California limited liability company ("Earlychildhood") and SmarterKids.com, Inc., a Delaware corporation ("SmarterKids.com"). As of March 31, 2001, LearningStar was nominally capitalized and its balance sheet was comprised solely of common stock subscriptions receivable of $10.00 and common stock of $10.00 representing 1,000 shares of outstanding common stock at a par value of $0.01 per share. The combination of Earlychildhood and SmarterKids.com (the "Combination") was completed on April 30, 2001 and each of Earlychildhood and SmarterKids.com became a wholly-owned subsidiary of LearningStar. As a result of the Combination, the former holders of outstanding membership interests in Earlychildhood and options to purchase membership interests in Earlychildhood own approximately two-thirds of the capital stock of LearningStar and the former holders of outstanding common stock of SmarterKids.com and options and warrants to purchase shares of common stock of SmarterKids.com own approximately one-third of the capital stock of LearningStar. As the former Earlychildhood members have a controlling interest in LearningStar following the Combination, the transaction has been recorded as if Earlychildhood acquired SmarterKids.com, with Earlychildhood deemed to be the predecessor of LearningStar. Accordingly, pursuant to Rules 3-01 through 3-04 of Regulation S- X, Earlychildhood's financial statements are included in Item 1 herein. A further discussion of the Combination and condensed pro forma financial information is included in Note 2. Earlychildhood, together with its wholly-owned subsidiary, Educational Products, Inc. ("EPI"), is a fully integrated, multi-channel supplier of educational products, services and information to schools, educational professionals and parents serving the early childhood and elementary school communities. The interim financial statements as of and for the three months ended March 31, 2001 and 2000 have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC") for interim financial reporting. These statements are unaudited and, in the opinion of management, include all adjustments (consisting only of normal recurring adjustments and accruals) necessary to present fairly the balance sheets and the statements of operations and cash flows for the periods presented. Operating results for the three months ended March 31, 2001 may not be indicative of the results for the year ending December 31, 2001. 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 in accordance with the rules and regulations of the SEC. These financial statements should be read in conjunction with the audited consolidated financial statements of Earlychildhood, and accompanying notes, included in Post-Effective Amendment No. 2 to LearningStar's Registration Statement on Form S-4 as filed with the SEC on April 27, 2001. Shipping and Handling Costs Shipping and handling revenues and shipping costs are included in revenues and cost of goods sold, respectively. Handling costs of $1,474 and $1,049 for the three months ended March 31, 2001 and 2000, respectively, are included in selling general and administrative expenses. Reclassifications Certain reclassifications, not affecting net loss, have been made to prior year amounts in order to conform to the 2001 financial statement presentation. Income Taxes Earlychildhood has elected to be taxed as a limited liability company (LLC) for federal and state income tax purposes. As an LLC, Earlychildhood's income and deductions are reported by its members who are taxed on such income or loss. EPI, a wholly-owned subsidiary of Earlychildhood, is a C corporation and therefore is subject to federal and state income taxes. LearningStar will be taxed as a C corporation. Accordingly, Earlychildhood's consolidated statement of operations for the three months ended March 31, 2001 and 2000 reflect pro forma income taxes as if Earlychildhood had elected to be taxed as a C corporation for federal and state income tax purposes during those periods. 6 EARLYCHILDHOOD LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (amounts in thousands, except share and per share amounts) (Unaudited) Recent Accounting Pronouncements In June 1998, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities" as amended by SFAS No. 137, which was issued in July 1999, and which delayed the adoption date for SFAS No. 133 until annual periods beginning after June 15, 2000. SFAS No. 133 established standards for recognition and measurement of derivatives and hedging activities. Earlychildhood adopted SFAS No. 133 beginning January 1, 2001. The adoption of SFAS No. 133 did not have a material effect on the financial position or results of operations of Earlychildhood. 2. Business Combination and Pro Forma Information On November 14, 2000, Earlychildhood entered into an agreement (as amended, the "Combination Agreement") to combine with SmarterKids.com. The Combination Agreement provided for (i) the holders of all of Earlychildhood's outstanding membership interests to contribute their entire ownership interest in Earlychildhood for LearningStar common stock and (ii) S-E Educational Merger Corp., a wholly-owned subsidiary of LearningStar, to be merged with and into SmarterKids.com and the outstanding shares of SmarterKids.com to be converted into shares of common stock of LearningStar. In addition, the Combination Agreement provided for holders of options to purchase Earlychildhood membership interests and holders of options and warrants to purchase SmarterKids.com common stock to have their options and warrants exchanged for or converted into, as the case may be, options or warrants, as applicable, to purchase common stock of LearningStar. After the exchange, Earlychildhood's members and option holders would own approximately two-thirds of LearningStar's shares on a fully-diluted basis. On April 30, 2001, the Combination was completed. The following table sets forth LearningStar common shares and options and warrants to purchase common shares which were issued upon completion of the Combination:
Common Options and Shares Warrants ------ ----------- Issued in exchange for: Membership interests in Earlychildhood 5,605,269 Shares of SmarterKids.com 2,725,776 Options of Earlychildhood 193,304 Options and warrants of SmarterKids.com 490,550 --------- -------- 8,331,045 683,854 ========= ========
The Combination will be accounted for as a purchase of SmarterKids.com by Earlychildhood. The estimated purchase price of $48,100 is based on the estimated fair value, determined around the time of announcing the Combination, of LearningStar common shares, options and warrants issued in exchange for SmarterKids.com common shares, options and warrants plus estimated transaction costs. 7 EARLYCHILDHOOD LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (amounts in thousands, except share and per share amounts) (Unaudited) The pro forma financial information in the following table illustrates the combined results of Earlychildhood's operations and the operations of SmarterKids.com for the three months ended March 31, 2001 and 2000, as if the acquisition of SmarterKids.com had occurred as of the beginning of each period presented. The pro forma financial information reflects the combination of Earlychildhood's and SmarterKids.com's results as adjusted primarily for amortization of goodwill and intangible assets resulting from the business combination. The pro forma financial information is presented for informational purposes and is not necessarily indicative of the results of operations which would have occurred had Earlychildhood and SmarterKids.com constituted a single entity as of January 1, 2001 or 2000. The pro forma information also is not necessarily indicative of the future results of operations of the combined company.
Three Months Ended March 31, -------------------------- 2001 2000 ------------ ------------ Net sales........................................................ $ 15,800 $ 13,972 Operating loss................................................... $ 11,125 $ 12,374 Pro forma net loss............................................... $ 12,196 $ 11,848 Pro forma basic and diluted net loss per share................... $ (1.49) $ (1.46) Shares used in pro forma basic and diluted net loss per share calculation......................................... 8,203,000 8,115,000
3. Unaudited Pro Forma Basic and Diluted Net Loss per Share The unaudited pro forma basic and diluted net loss per share information included in the accompanying statements of operations for the three months ended March 31, 2001 and 2000 reflects the impact of the conversion of all Earlychildhood membership interests into common shares of LearningStar in conjunction with the Combination as of the beginning of each period or date of issuance, if later. Common equivalent shares of 20,233 have not been included in the computation of diluted net loss per share for the three months ended March 31, 2001 as the effect is anti-dilutive. Common equivalent shares consist of membership interests issuable upon the exercise of options granted in September 2000. Historical basic and diluted net loss per share have not been presented because they are irrelevant due to the significant change in LearningStar's capital structure and resultant basic and diluted net loss per share that will result upon conversion of all Earlychildhood membership interests into common shares of LearningStar. The following table sets forth the computation of pro forma basic and diluted net loss per share for the three months ended March 31, 2001 and 2000.
Three Months Ended March 31, -------------------------------- 2001 2000 Pro forma net loss.................................................... $ (1,679) $ (1,590) Weighted average shares outstanding assuming conversion of membership interests to LearningStar common stock: Class A membership interests 2,942,242 2,942,242 Class B membership interests 2,621,124 2,621,124 Class C membership interests 41,903 12,701 ----------- ----------- Shares used in pro forma per share calculation - basic and diluted 5,605,269 5,576,067 =========== =========== Pro forma net loss per share - basic and diluted $ (0.30) $ (0.29) =========== ===========
8 EARLYCHILDHOOD LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (amounts in thousands, except share and per share amounts) (Unaudited) 4. Segment Information Earlychildhood presently operates in two segments, Discount School Supply (DSS) and EPI. DSS includes the brand names Discount School Supply, Earlychildhood NEWS and Earlychildhood. DSS supplies educational products and information through multiple channels to early childhood professionals and parents. EPI sells school supplies to elementary schools, teachers and other educational organizations. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies. There were no intersegment sales. Earlychildhood's profit measure of EBITDA represents net income adding back depreciation and amortization, interest and income taxes. Information regarding DSS and EPI is as follows (in thousands):
Three Months Ended March 31, ------------------------- 2001 2000 ---------- ----------- Revenues: DSS......................................... $11,945 $10,380 EPI......................................... 1,984 2,123 --------------------- Total....................................... 13,929 12,503 ======= ======= EBITDA: DSS......................................... $ (675) $ (772) EPI......................................... (984) (941) --------------------- Total....................................... $(1,659) $(1,713) ======= =======
DSS performs limited administrative activities, including certain accounting and information system functions on behalf of EPI. DSS charges EPI based on estimates of its actual costs for such activities. Intersegment charges amounted to $27,000 and $37,000 for the three months ended March 31, 2001 and 2000, respectively. 5. Subsequent Event In April 2001, LearningStar entered into a secured credit facility with GMAC Business Credit, LLC ("GMAC"). At the same time, Earlychildhood repaid its obligations aggregating $16,389 under its existing credit facility with BNP Paribas (the "Paribas Credit Facility") and the Paribas Credit Facility was terminated. Accordingly, borrowings under the Paribas Credit Facility are reflected as current obligations as of March 31, 2001. LearningStar's credit facility with GMAC includes a $25,000 line of credit with a maturity of April 30, 2004, an interest rate of LIBOR plus 3.0% and a minimum excess availability requirement of $4,000 at all times. The facility has a credit limit at any time of an amount equal to the sum of 80% of the aggregate face amount of eligible accounts receivable plus the lowest of (i) 50% of LearningStar's inventory; (ii) 85% times net liquidation percentage of inventory (the liquidation percentage is periodically set by the lender); or (iii) the result of $18,000 minus the eligible portion of EPI's inventory. The credit line also requires certain financial covenants and restrictions on capital expenditures during the term of the facility. As of May 1, 2001, LearningStar had borrowings of $5,000 and available borrowing capacity of $4,000 under the new credit facility with GMAC. 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion contains forward-looking statements which involve risks and uncertainties. LearningStar makes these forward-looking statements under the provision of the "Safe Harbor" section of the Private Securities Litigation Reform Act of 1995. Any forward-looking statements should be considered in light of the factors described in the risk factors attached hereto as Exhibit 99.1 and incorporated herein by reference. Actual results may vary materially from those projected, anticipated or indicated in any forward-looking statements. In this Item 2, the words "anticipates," "believes," "expects," "intends," "future," "could," and similar words or expressions (as well as other words or expressions referencing future events, conditions, or circumstances) identify forward- looking statements. The following discussion and analysis should be read in conjunction with the accompanying financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. Overview LearningStar was incorporated in the State of Delaware on November 6, 2000 for the purpose of effecting the Combination of the businesses of Earlychildhood and SmarterKids.com. As of March 31, 2001, LearningStar was nominally capitalized and its balance sheet was comprised solely of common stock subscriptions receivable of $10.00 and common stock of $10.00 representing 1,000 shares of outstanding common stock at a par value of $0.01 per share. The Combination was completed on April 30, 2001 and each of Earlychildhood and SmarterKids.com became a wholly-owned subsidiary of LearningStar. As a result of the Combination, the former holders of outstanding membership interests in Earlychildhood and options to purchase membership interests in Earlychildhood own approximately two-thirds of the capital stock of LearningStar and the former holders of outstanding common stock of SmarterKids.com and options and warrants to purchase shares of common stock of SmarterKids.com own approximately one- third of the capital stock of LearningStar. As the former Earlychildhood members have a controlling interest in LearningStar following the Combination, the transaction has been recorded as if Earlychildhood acquired SmarterKids.com, with Earlychildhood deemed to be the predecessor of LearningStar. Accordingly, Earlychildhood's results of operations and financial condition are discussed below. A further discussion of the Combination is included under "Combination with SmarterKids.com" below. Earlychildhood is a fully-integrated, multi-channel supplier of educational products, services and information to schools, educational professionals and parents serving the early childhood and elementary school communities. Through a predecessor entity, Earlychildhood began operations in 1985. Earlychildhood manufactures, imports and sells company-developed products as part of its diverse mix of school supplies and educational toys, while also distributing and selling a carefully selected range of third-party brands such as Crayola(R), Lego(R) and Elmer's(R). Earlychildhood utilizes multiple sales, marketing and distribution channels, including: . its catalogs issued under its tradename, Discount School Supply, or DSS; . sales programs conducted through its wholly-owned subsidiary, Educational Products, Inc., or EPI; . the Earlychildhood website; and . Earlychildhood NEWS, a professional content resource published in print and online. All of the foregoing are supported by a national sales force which, as of March 31, 2001, numbered 85 people. Earlychildhood presently operates in two segments: Discount School Supply, or DSS, and EPI. DSS includes the brand names Discount School Supply, Earlychildhood NEWS and Earlychildhood. DSS supplies educational products and information through multiple channels to early childhood professionals and parents. EPI sells school supplies to elementary schools, teachers and other educational organizations. LearningStar is in the process of reviewing its organizational reporting and, as such, operating segments may be subject to change in the future. 10 Combination with SmarterKids.com On November 14, 2000, Earlychildhood entered into an agreement (as amended, the "Combination Agreement") to combine with SmarterKids.com. The Combination Agreement provided for (i) the holders of all of Earlychildhood's outstanding membership interests to contribute their entire ownership interest in Earlychildhood for LearningStar common stock and (ii) S-E Educational Merger Corp., a wholly-owned subsidiary of LearningStar, to be merged with and into SmarterKids.com and the outstanding shares of SmarterKids.com to be converted into shares of common stock of LearningStar. In addition, the agreement provided for holders of options to purchase Earlychildhood membership interests and holders of options and warrants to purchase SmarterKids.com common stock to have their options and warrants exchanged for or converted into, as the case may be, options or warrants, as applicable, to purchase common stock of LearningStar. After the exchange, Earlychildhood's members and option holders would own approximately two-thirds of LearningStar's shares on a fully-diluted basis. On April 30, 2001, the Combination was completed. The following table reflects LearningStar common shares and options and warrants to purchase common shares which were issued upon completion of the Combination:
Common Options and Shares Warrants ------ ----------- Issued in exchange for: Membership interests in Earlychildhood 5,605,269 Shares of SmarterKids.com 2,725,776 Options of Earlychildhood 193,304 Options and warrants of SmarterKids.com 490,550 --------- -------- 8,331,045 683,854 ========= ========
The Combination will be accounted for as a purchase of SmarterKids.com by Earlychildhood. The estimated purchase price of $48.1 million is based on the estimated fair value, determined around the time of announcing the Combination, of LearningStar common shares, options and warrants issued in exchange for SmarterKids.com common shares, options and warrants plus estimated transaction costs. 11 Results of Operations Revenues. Revenues were $13.9 million and $12.5 million for the three months - --------- ended March 31, 2001 and 2000, respectively. The increase in revenue from 2000 to 2001 of $1.4 million, or 11.2%, was attributable to increases at DSS of $1.6 million and a decrease in EPI's revenue of $100,000. DSS's contribution to increased revenue is attributable to increases in its customer base and the number of pages per catalog, catalogs sent and products offered. Gross Profit. Gross profit was $5.6 million and $4.6 million for the three - ------------- months ended March 31, 2001 and 2000, respectively. Gross profit as a percentage of sales increased from 36.6% to 40.2%. The increase in gross profit percentage was primarily attributable to increased margins at DSS resulting from pricing strategy, greater efficiencies in paint manufacturing and economies of scale associated with purchasing inventory. Selling, General and Administrative Expenses. Selling, general and - --------------------------------------------- administrative expenses include wages and commissions, catalog costs, operating expenses (which include customer service and certain warehouse costs), administrative costs (which include information systems, accounting and human resources), e-business costs and depreciation of property and equipment. Selling, general and administrative expenses were $7.6 million and $6.4 million for the three months ended March 31, 2001 and 2000, respectively. The increase in selling, general and administrative expense was partially attributable to the addition of a new warehouse facility in Salinas, California as well as the expansion of Earlychildhood's Harrisburg, Pennsylvania facility. The remaining costs were related to investment in DSS's marketing and infrastructure, including personnel, catalog production and fulfillment capacity. Amortization of Goodwill and Other Intangible Assets. Amortization of goodwill - ----------------------------------------------------- and other intangible assets was comparable for the three months ended March 31, 2001 and 2000. Interest Expense. Interest expense was $292,000 and $318,000 in the three months - ----------------- ended March 31, 2001 and 2000, respectively. The decrease in interest expense is primarily related to more favorable LIBOR rates with respect to the interest rate charged per the Paribas Credit Facility. Income Tax Benefit. As a limited liability company, Earlychildhood is not - ------------------- subject to income taxes; however, its wholly-owned subsidiary, EPI, is a C corporation, and is therefore subject to federal and state income taxes. Income tax benefit was $376,000 and $513,000 for the three months ended March 31, 2001 and 2000, respectively. The effective income tax rates were 14% and 21% for March 31, 2001 and 2000, respectively. The effective rates were lower than statutory rates primarily due to the impact of losses relating to DSS's operations for which no tax benefit is derived due to Earlychildhood's LLC status. Liquidity and Capital Resources Historically, Earlychildhood's primary cash needs have been for working capital, capital expenditures and acquisitions to fund its growth. The primary sources of liquidity have been the Paribas Credit Facility and capital contributions from its members. As of March 31, 2001, Earlychildhood had net working capital of $2.5 million. Capitalization consisted of limited liability company membership interests of $16.3 million. As a result of the Combination, LearningStar received access to approximately $23 million of SmarterKids.com pre-combination cash balance and short-term investments. In addition, in April 2001, LearningStar entered into a secured credit facility with GMAC Business Credit, LLC (the "GMAC Facility"). At the same time, Earlychildhood repaid its obligations aggregating $16,389,000 under the Paribas Credit Facility and the facility was terminated. Accordingly, borrowings under the Paribas Credit Facility are reflected as a current obligation as of March 31, 2001. The GMAC Facility includes a $25 million line of credit with a maturity of April 30, 2004, and interest rate of LIBOR plus 3.0% and a minimum excess availability requirement of $4.0 million at all times. The facility has a credit limit at any time of an amount equal to the sum of 80% of the aggregate face amount of eligible accounts receivable; plus the lowest of (i) 50% of LearningStar's inventory; (ii) 85% times net liquidation percentage of inventory (the liquidation percentage is periodically set by the lender); or (iii) the result of $18 million minus the eligible portion of EPI's inventory. The credit line also requires certain financial covenants and restrictions on capital expenditures during the term of the facility. As of May 1, 2001, LearningStar had borrowings of $5 million and available borrowing capacity of $4 million under the GMAC Facility. Management anticipates that operating cash requirements for LearningStar will be higher in the near future than historical cash requirements at Earlychildhood due to the costs associated with integrating Earlychildhood and 12 SmarterKids.com. However, it is anticipated that the operating cash flows relating to the SmarterKids.com component of LearningStar will be significantly lower than SmarterKids.com's historical operating cash outflows. Management believes that available cash on hand subsequent to the combination and availability under the GMAC revolving credit facility will provide adequate funds for LearningStar's foreseeable working capital needs and planned capital expenditures. During the three months ended March 31, 2001, Earlychildhood's operating activities used $1.2 million in cash. The use of cash was primarily related to operating losses and increases in inventories, offset in part by increases in accounts payable. Earlychildhood generated $1.6 million in cash from financing activities. The cash generated from financing activities was primarily related to borrowings on the line of credit. During the three months ended March 31, 2001, Earlychildhood's investing activities used $487,000 in cash; primarily related to purchases of plant and equipment. Earlychildhood's ability to fund its operations, make scheduled debt payments and planned capital expenditures and to remain in compliance with its financial covenants under its credit facility depends on its future operating performance and cash flow, which in turn, are subject to prevailing economic conditions and to financial, business and other factors, some of which are beyond its control. Seasonality Earlychildhood's seasonal sales trends coincide with the start of each school year. Accordingly, the majority of revenues are generated in the second and third calendar quarter, with a particular emphasis on the third quarter which generally represents 40% to 50% of Earlychildhood's annual sales. Earlychildhood's working capital needs are greatest during the second calendar quarter as inventory levels are increased to meet seasonal demands. Inflation Inflation has and is expected to have only a minor effect on Earlychildhood's results of operations and sources of liquidity. Recent Accounting Pronouncements In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" as amended by SFAS No. 137, which was issued in July 1999, and which delayed the adoption date for SFAS No. 133 until annual periods beginning after June 15, 2000. SFAS No. 133 established standards for recognition and measurement of derivatives and hedging activities. Earlychildhood adopted SFAS No. 133 beginning January 1, 2001. The adoption of SFAS No. 133 did not have a material effect on the financial position or operations of Earlychildhood. 13 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The following discussion of market risk includes "forward-looking statements" that involve risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements. LearningStar does not use derivative financial instruments for speculative or trading purposes. Interest Rate Risk LearningStar's financial instruments include cash and cash equivalents, accounts receivable, accounts payable and a revolving line of credit. Market risks relating to operations result primarily from a change in interest rates. LearningStar's borrowings are primarily dependent upon LIBOR rates. In April 2001, LearningStar entered into the GMAC Facility with initial outstanding borrowings of $5 million as of May 1, 2001. The estimated fair value of borrowings under the GMAC Facility is expected to approximate its carrying value. Credit Risk Financial instruments which potentially subject LearningStar to concentrations of credit risk consist primarily of cash, cash equivalents, accounts receivable and the revolving line of credit. LearningStar has no customer comprising greater than 10% of its revenues. However, receivables arising from the normal course of business are not collateralized and management continually monitors the payment of its accounts receivable and the financial condition of its customers to reduce the risk of loss. LearningStar does not believe that its cash and cash equivalents are subject to any unusual credit risk beyond the normal credit risk associated with commercial banking relationships. Foreign Currency Risk LearningStar purchases some of its products from foreign vendors. Accordingly, LearningStar's prices of imported products are subject to variability based on foreign exchange rates. However, LearningStar's purchase orders are denominated in U.S. dollars and LearningStar does not enter into long-term purchase commitments. PART II: OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In a demand letter dated July 13, 1999, Showboard, Inc. claimed that one of EPI's products infringed on Showboard's single and double-wall display board patents (U.S. Patent Nos. 4,794,712, 5,293,705, and 5,911,522). The EPI product at issue was EPI's single-wall display boards, which are used primarily for the display of science projects. By letter dated March 6, 2000, counsel to Earlychildhood responded that Earlychildhood did not believe that these patents were infringed because EPI's display boards are not substantially similar to those of Showboard. No response has been received from Showboard. No complaint has been filed, nor is any litigation pending over this issue. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 14 ITEM 5. OTHER INFORMATION (a) Financial Statements of SmarterKids.com, Inc. As a result of the Combination, the former holders of outstanding membership interests in Earlychildhood and options to purchase membership interests in Earlychildhood own approximately two-thirds of the capital stock of LearningStar and the former holders of outstanding common stock of SmarterKids.com and options and warrants to purchase shares of common stock of SmarterKids.com own approximately one-third of the capital stock of LearningStar. As the former Earylchildhood members have a controlling interest in LearningStar following the Combination, the transaction has been recorded for accounting purposes as if Earlychildhood acquired SmarterKids.com, with Earlychildhood deemed to be the predecessor of LearningStar. Accordingly, pursuant to Rules 3-01 and 3-04 of Regulation S-X, Earlychildhood's financial statements are included in Item 1 herein. Given the nature of the Combination and since SmarterKids.com constitutes a significant acquisition to Earlychildhood, the corresponding financial statements of SmarterKids.com for the three months ended March 31, 2001 and 2000 are included below. SMARTERKIDS.COM, INC. BALANCE SHEET ------------- (in thousands, except share data) (Unaudited)
March 31, December 31, --------- ------------ 2001 2000 ---- ---- ASSETS Current assets: Cash and cash equivalents.............................................................. $ 24,011 $ 17,557 Short-term investments................................................................. 1,083 13,831 Accounts receivable, net of allowance for doubtful accounts of $0 and $9 at March 31, 2001 and December 31, 2000, respectively................................... 79 232 Inventories............................................................................ 462 2,080 Other current assets................................................................... 1,845 1,844 -------- -------- Total current assets............................................................. 27,480 35,544 Property and equipment, net................................................................ 4,981 5,296 Other assets............................................................................... 1,468 1,546 Intangible assets, net..................................................................... 187 274 Restricted cash............................................................................ 1,028 1,028 -------- -------- Total assets..................................................................... $ 35,144 $ 43,688 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current portion of long term debt and capital lease obligations........................ $ 518 $ 525 Accounts payable....................................................................... 2,674 5,089 Accrued expenses....................................................................... 6,371 4,418 Deferred revenue....................................................................... 176 188 Other current liabilities.............................................................. - 30 -------- -------- Total current liabilities........................................................ 9,739 10,250 Long term debt and capital lease obligations, net of current portion....................... 547 685 -------- -------- Total liabilities................................................................ 10,286 10,935 -------- -------- Commitments and contingencies (Note 4) - - Stockholders' equity: Common stock, $0.01 par value; 90,000,000 shares authorized; 20,832,711 and 20,668,849 shares issued and outstanding at March 31, 2001 and December 31, 2000, respectively....................................................... 208 207 Additional paid-in capital............................................................. 111,488 111,809 Deferred stock compensation............................................................ (2,467) (3,399) Accumulated deficit.................................................................... (84,371) (75,864) -------- -------- Total stockholders' equity........................................................ 24,858 32,753 -------- -------- Total liabilities and stockholders' equity........................................ $ 35,144 $ 43,688 ======== ========
The accompanying notes are an integral part of these financial statements. 15 SMARTERKIDS.COM, INC. STATEMENT OF OPERATIONS (in thousands, except per share data) (Unaudited)
For the Three Months Ended March 31, -------------------- 2001 2000 ---- ---- Net revenues.................................................................. $ 1,871 $ 1,469 Cost of revenues.............................................................. 1,875 1,101 ------- ------- Gross profit (loss)........................................................... (4) 368 ------- ------- Operating expenses: Marketing and sales (including stock compensation of $204 and $309 for the three months ended March 31, 2001 and 2000, respectively)............ 3,772 7,609 Development (including stock compensation of $49 and $(281) for the three months ended March 31, 2001 and 2000, respectively)...................... 823 662 General and administrative (including stock compensation of $316 and $150 for the three months ended March 31, 2001 and 2000, respectively)........ 812 1,056 Restructuring costs....................................................... 2,315 - ------- ------- Total operating expenses............................................ 7,722 9,327 ------- ------- Loss from operations.......................................................... (7,726) (8,959) Interest and other income (expense), net...................................... (781) 828 ------- ------- Net loss attributable to common stockholders.................................. $(8,507) $(8,131) ======= ======= Basic and diluted net loss per common share................................... $ (0.41) $ (0.40) Weighted average shares outstanding-basic and diluted......................... 20,785 20,308
The accompanying notes are an integral part of these financial statements. 16 SMARTERKIDS.COM, INC. STATEMENT OF CASH FLOWS (in thousands) (Unaudited)
For the Three Months Ended March 31, ---------------------------- 2001 2000 --------- -------- Cash flows from operating activities: Net loss .............................................................................. $(8,507) $ (8,131) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization ....................................................... 672 365 Stock compensation expense .......................................................... 569 178 Changes in assets and liabilities: Accounts receivable .............................................................. 153 92 Inventories ...................................................................... 1,618 1,665 Other current assets ............................................................. (1) (324) Other long-term assets ........................................................... 78 -- Accounts payable ................................................................. (2,415) (7,397) Accrued expenses ................................................................. 1,953 (2,571) Deferred revenue................................................................... (12) (31) Other current liabilities.......................................................... (30) (15) ------- -------- Net cash used in operating activities ................................................... (5,922) (16,169) ------- -------- Cash flows from investing activities: Purchase of short-term investments ............................................... -- (21,702) Purchases of property and equipment .............................................. (270) (1,742) Sale of short-term investments ................................................... 12,748 -- ------- -------- Net cash provided by (used in) investing activities ..................................... 12,478 (23,444) ------- -------- Cash flows from financing activities: Proceeds from long-term borrowings................................................. -- 1,267 Repayments of long-term borrowings................................................. (145) (100) Proceeds from exercise of common stock options ................................... 18 13 Proceeds from the purchase of common stock under the Employee Stock Purchase Plan...................................................................... 25 -- Increase from estimated IPO costs.................................................. -- (204) ------- -------- Net cash provided by (used in) financing activities ..................................... (102) 976 ------- -------- Net increase (decrease) in cash and cash equivalents .................................... 6,454 (38,637) Cash and cash equivalents at beginning of period ........................................ 17,557 55,621 ------- -------- Cash and cash equivalents at end of period .............................................. $24,011 $ 16,984 ======= ========
The accompanying notes are an integral part of these financial statements. 17 SMARTERKIDS.COM, INC. NOTES TO FINANCIAL STATEMENTS ----------------------------- (Unaudited) 1. Basis of Presentation: The interim financial statements as of and for the three months ended March 31, 2001 and 2000 have been prepared by SmarterKids.com, Inc. ("SmarterKids.com") pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC") for interim financial reporting. These statements are unaudited and, in the opinion of management, include all adjustments (consisting only of normal recurring adjustments and accruals) necessary to present fairly the balance sheet and the statements of operations and cash flows for the periods presented. Operating results for the three months ended March 31, 2001 and 2000 may not be indicative of the results for the year ending December 31, 2001. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted in accordance with the rules and regulations of the SEC. These financial statements should be read in conjunction with the audited financial statements and accompanying notes included in SmarterKids.com's Annual Report on Form 10-K for the year ended December 31, 2000. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent liabilities at the period end, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Marketing and Sales Expenses Marketing and sales expenses consist primarily of the cost of advertising and promotional activities, fulfillment costs, including service fees to J.L. Hammett Co. in 2000, commissions to online marketing companies and expenses for personnel engaged in marketing and merchandising. Fulfillment costs represent costs incurred in operating and staffing the distribution center and the customer service department, picking and packing customers' orders for shipment, responding to inquires from customers, credit card fees, as well as fees paid to J.L. Hammett Co., a fulfillment partner during the first six months of 2000. As of July 1, 2000, SmarterKids.com discontinued using J.L. Hammett Co. as a third party fulfillment partner due to the opening of its own distribution facility. Fulfillment costs were $1,085,000 and $1,068,000 for the quarters ended March 31, 2001 and 2000, respectively. Advertising costs are charged to operations as incurred. Advertising expenses were $540,000 and $3,849,000 for the quarters ended March 31, 2001 and 2000, respectively. Recent Accounting Pronouncements In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities" as amended by SFAS No. 137, which was issued in June 2000. SmarterKids.com adopted SFAS No. 133 in the first quarter of 2001. SFAS No. 133 requires that all derivative instruments be reported on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. Adoption of SFAS No. 133 did not have a significant impact on SmarterKids.com's financial condition, results of operations, or business practices. 18 SMARTERKIDS.COM, INC. NOTES TO FINANCIAL STATEMENTS--(Continued) ------------------------------------------ (Unaudited) 2. Property and Equipment: Property and equipment consist of the following (in thousands):
March 31, December 31, --------- ----------- 2001 2000 --------- ----------- Software ............................................ $1,951 $1,868 Furniture and fixtures .............................. 234 232 Computer and office equipment ....................... 4,251 4,066 Leasehold improvements .............................. 1,275 1,275 ------ ------ 7,711 7,441 Less--Accumulated depreciation and amortization ..... 2,730 2,145 ------ ------ $4,981 $5,296 ====== ======
3. Restructuring Charges During the fourth quarter of 2000, SmarterKids.com approved and implemented a restructuring program in order to reduce operating expenses in its business. The restructuring plan is expected to be completed by June 2001. The program included a net reduction of 60% of SmarterKids.com's workforce. Accordingly, during the fourth quarter of 2000, SmarterKids.com recorded a charge of $1.3 million related to employee termination benefits. During the first quarter of 2001, SmarterKids.com amended its plan to further include the closing of its warehouse facility in Mansfield, Massachusetts and the transfer of its fulfillment operations to Earlychildhood. Accordingly, SmarterKids.com recorded an additional charge of $2.3 million, reflecting lease termination costs and a write-off of abandoned fixed assets, net of expected sale proceeds. As of March 31, 2001, $540,000 has been paid out and $3.1 million remains accrued. Commitments and Contingencies: 4. Restricted Time Deposit In connection with a facility lease entered into in 1999, SmarterKids.com is required to maintain, on behalf of the landlord, a certificate of deposit in the amount of $500,000, which is restricted as to its use. In connection with the warehouse facility lease entered into in the second quarter of 2000, SmarterKids.com was required to maintain, on behalf of the landlord, $500,000 in an interest-bearing account, which was restricted as to its use. The warehouse facility lease was terminated as of April 30, 2001 in connection with the restructuring plan SmarterKids.com adopted in the first quarter of 2001 (Note 3). 5. Subsequent events In November 2000, SmarterKids.com entered into a Contribution Agreement and Plan of Reorganization and Merger with Earlychildhood, LearningStar and S-E Educational Merger Corp. This contribution agreement provides for the combination of SmarterKids.com with Earlychildhood. The shareholders of SmarterKids.com approved the Contribution Agreement on April 9, 2001 at the Special Meeting of SmarterKids.com Shareholders. Pursuant to this Contribution Agreement, the combination of SmarterKids.com and Earlychildhood was effected on April 30, 2001 by (1) the merger of S-E Educational Merger Corp. with and into SmarterKids.com such that SmarterKids.com became a wholly-owned subsidiary of LearningStar, and (2) the contribution of all the outstanding membership interests in Earlychildhood to LearningStar, such that Earlychildhood became a wholly-owned subsidiary of LearningStar. 19 (b) SmarterKids.com Management's Discussion and Analysis of Financial Condition and Results of Operations Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the accompanying financial statements for the periods specified and the associated notes. Further reference should be made to SmarterKids.com's Annual Report on Form 10-K for the year ending December 31, 2000. The following discussion contains forward-looking statements which involve risks and uncertainties. LearningStar makes such forward-looking statements under the provision of the "Safe Harbor" section of the Private Securities Litigation Reform Act of 1995. Any forward-looking statements should be considered in light of the factors described below under "Certain Factors That May Affect Future Results." Actual results may vary materially from those projected, anticipated or indicated in any forward-looking statements. The words "anticipates," "believes," "expects," "intends," "future," "could," and similar words or expressions (as well as other words or expressions referencing future events, conditions, or circumstances) identify forward-looking statements. The following discussion and analysis should be read in conjunction with the accompanying financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. Overview SmarterKids.com is an online, educational store dedicated to helping parents help their children learn, develop, and grow. The site offers what management believes to be one of the Internet's most personalized shopping experiences, linking teacher-reviewed toys, games, books, software, and hands-on activities through SmarterKids.com's patent-pending evaluation and recommendation process. SmarterKids.com serves as a resource for parents, offering specialty centers, the Grade Expectations! guide to education standards and thousands of educational products, including both well-known brands and hard-to-find quality offerings, for children aged infant through 12. Results of Operations Revenues. Revenues in 2001 and 2000 consisted of online sales of third-party educational products and charges to customers for shipping. Also included in revenues are online sales of SmarterKids.com's proprietary CD-ROM products, which are offered on a limited basis. In the quarters ended March 31, 2001 and 2000, SmarterKids.com derived approximately 2% of its revenues from outside of the United States. Revenues are recognized when the products are received by customers and are net of promotional discounts, coupons and return allowances, which are determined by historical trends of actual returns. Revenues were $1.9 million and $1.5 million in the quarters ended March 31, 2001 and 2000, respectively. The increase in revenue in the quarter ended March 31, 2001 from the quarter ended March 31, 2000 resulted from increased purchases from repeat customers and increased promotional efforts. SmarterKids.com began a liquidation strategy of its year-end inventory, which included several promotional events, in connection with introducing a new product mix in the second quarter of 2001, and transferring fulfillment services to Earlychildhood in March 2001. Cost of revenues. Cost of revenues consists primarily of the cost of products sold to customers and the cost of shipping products to SmarterKids.com's customers. SmarterKids.com anticipates that its gross margins will fluctuate from quarter to quarter depending on consumer preferences for its mix of products. The cost of revenues was $1.9 million and $1.1 million in the quarters ended March 31, 2001 and 2000, respectively. The increase in cost of revenues in the quarter ended March 31, 2001 from the quarter ended March 31, 2000 was principally attributable to an inventory liquidation strategy related to introducing a new product mix in the second quarter 2001 and transferring fulfillment services to Earlychildhood in March 2001. The decrease in gross margin to negative 0.21% in the quarter ended 2001 from 25% in the quarter ended 2000 was a direct result of a liquidation strategy where SmarterKids.com held several promotional events with lowered retail prices in order to reduce the inventory on hand in connection with the outsourcing of SmarterKids.com's fulfillment services and the introduction of a new product mix in the second quarter of 2001. 20 Marketing and sales. Marketing and sales expenses consist primarily of the cost of advertising and promotional activities, fulfillment costs, commissions to online marketing companies expenses for personnel engaged in marketing, merchandising activities and stock compensation expense. Fulfillment costs represent costs incurred in operating and staffing the distribution center and the customer service department, picking and packing customers' orders for shipment, responding to inquires from customers, credit card fees, as well as fees paid to J.L. Hammett Co., a fulfillment partner during the first six months of 2000. As of July 1, 2000, SmarterKids.com discontinued using J.L. Hammett Co. as a third party fulfillment partner due to the opening of its own distribution facility. As of March 31, 2001, SmarterKids.com transferred its fulfillment to Earlychildhood in connection with the Combination. Marketing and sales expenses were $3.8 million and $7.6 million in the quarters ended March 31, 2001 and 2000, respectively. Included in marketing and sales expenses were stock compensation expenses of $204,000 and $309,000 for the quarter ended March 31, 2001 and 2000, respectively. The decrease in the quarter ended March 31, 2001 from the quarter ended March 31, 2000 was primarily attributable to decreased advertising and promotional activities and a reduction of headcount related to SmarterKids.com restructuring plan adopted in the fourth quarter of 2000. Fulfillment costs included in marketing and sales expense were $1.1 million in each of the quarters ended March 31, 2001 and 2000. In September 2000, the Emerging Issues Task Force (EITF) reached a final consensus on EITF Issue 00-10, "Accounting for Shipping and Handling Fees and Costs." This consensus states that all amounts billed to a customer in a sale transaction related to shipping and handling, if any, represent revenue and should be classified as revenue. SmarterKids.com classifies shipping charges to customers as revenue. With respect to the classification of costs related to shipping and handling incurred by the seller, including fulfillment costs, the EITF determined that the classification and amount of such costs is an accounting policy decision that should be disclosed. SmarterKids.com classifies fulfillment costs as marketing and sales expenses. These costs are primarily composed of distribution facility expenses, including equipment and supplies, payroll and travel expenses for personnel engaged in distribution activities, third party fulfillment fees, credit card fees and the costs of customer support. These costs represent facility costs necessary for warehousing inventory, as well as costs incurred to pick and pack a customer order and the related packaging supplies. Development. Development expenses consist primarily of payroll and related costs for personnel performing website design, development, maintenance and testing. Development expenses were $823,000 and $662,000 in the quarters ended March 31, 2001 and 2000, respectively. Included in development costs were stock compensation expenses (credits) of $49,000 and ($281,000) for the quarters ended March 31, 2001 and 2000, respectively. The decrease in the quarter ended March 31, 2001 from the quarter ended March 31, 2000 was attributable primarily to reduced overhead allocations. General and administrative. General and administrative expenses consist primarily of payroll and related costs for executive and administrative personnel, professional service expenses and other general corporate expenses. General and administrative expenses were $812,000 and $1,056,000 in the quarters ended March 31, 2001 and 2000, respectively. Included in general and administrative expenses were stock compensation expenses of $316,000 and $150,000. The decrease in the quarter ended March 31, 2001 from the quarter ended March 31, 2000 was attributable primarily to reductions in headcount related to SmarterKids.com's restructuring plan adopted in the fourth quarter of 2000. Stock compensation. With respect to stock options granted to employees, SmarterKids.com recorded non-cash stock compensation expense of $569,000 and $178,000 in the quarters ended March 31, 2001 and 2000, respectively, related to amortization of deferred stock compensation for options and warrants granted to employees and non-employees and, with respect to first quarter 2001 the acceleration of vesting on certain employee options. For non-employee grants, the compensation charge reflects the fair value of the options and warrants on the initial measurement date (typically the date of grant for those exercisable immediately or with fixed vesting periods, or the date when vesting becomes fixed for those with variable vesting periods), as well as subsequent re- measurements of such fair value until the options and warrants vest. Accordingly, SmarterKids.com cannot currently estimate additional charges related to future re-measurement of unvested non-employee options and warrants. 21 On September 7, 2000, SmarterKids.com completed a direct repricing of certain employee stock option grants. As part of the repricing, SmarterKids.com reduced the exercise price of all outstanding options with exercise prices of greater than $1.50 per share. The new exercise price of these repriced options was reset to $1.50 per share, which was equal to the market value of the common stock on September 7, 2000. Options to purchase 2,325,574 shares of SmarterKids.com common stock were repriced. SmarterKids.com is accounting for the repriced options as a variable award. In the quarter ended March 31, 2001, SmarterKids.com did not record any additional non-cash stock compensation charges as a result of this repricing since the market price of the common stock at March 31, 2001 was less than the repriced exercise price. Restructuring charges. During the fourth quarter of 2000, SmarterKids.com approved and implemented a restructuring program in order to reduce operating expenses. The restructuring plan is expected to be completed by June 2001. The program included a net reduction of 60% of its workforce. Accordingly, during the fourth quarter of 2000, SmarterKids.com recorded a charge of $1.3 million related to employee termination benefits. During the first quarter of 2001, SmarterKids.com recorded additional restructuring charges of $2.3 million related to the closing of its warehouse and transfer of fulfillment operations to Earlychildhood. As of March 31, 2001, $540,000 has been paid out and $3.1 million remains accrued. Interest Income and Expense, Other Income and Expense. Interest income consists primarily of interest earned on capital invested in commercial paper and corporate and treasury notes. Interest expense is related to short-term lease obligations and borrowings under SmarterKids.com's equipment lines of credit. Also included in other expense in the quarter ended March 31, 2001 are transaction expenses related to the proposed combination with Earlychildhood. The transaction expenses consist primarily of legal, accounting and investment banking fees. Interest and other income (expense), net decreased to ($781,000) in the quarter ended March 31, 2001 from $828,000 in the quarter ended March 31, 2000. The decrease was primarily attributable to a decrease in interest income due to decreased levels of cash, cash equivalents and short-term investments and to transaction expenses of $1.2 million. Liquidity and Capital Resources Since its inception, SmarterKids.com has incurred significant losses. SmarterKids.com has met its cash requirements primarily through the sale of capital stock and the use of lines of credit and capital leases. SmarterKids.com has received capital from investors in three private venture capital financings totaling $37.0 million through July 1999. On November 23, 1999, SmarterKids.com completed an initial public offering of 4,500,000 shares of common stock, resulting in net proceeds of $65.9 million. The primary purposes of the initial public offering were to increase SmarterKids.com's capitalization and financial flexibility, create a public market for SmarterKids.com's common stock, and facilitate future access to public markets. As of March 31, 2001, SmarterKids.com had used $40.8 million of the offering proceeds for working capital. Net cash used in operating activities was $5.9 million and $16.2 million in the three months ended March 31, 2001 and 2000, respectively. The decrease in net cash used in operating activities from the three months ended March 31, 2000 to the three months ended March 31, 2001 was primarily attributable to the reduction of operating expenses in connection with SmarterKids.com's restructuring initiatives. SmarterKids.com expects that operating cash requirements will decrease as the savings from the restructuring plan takes further effect. Net cash provided by investing activities was primarily a result of the sale of short-term investments. Net cash used in investing activities in the three months ended March 31, 2000 was primarily for purchases of fixed assets and short-term investments. Cash provided in investing activities was $12.5 million in the three months ended March 31, 2001. Cash used in investing activities was $23.4 million in the three months ended March 31, 2000. Net cash used by financing activities was $103,000 in the three months ended March 31, 2001. Net cash provided by financing activities was $976,000 in the three months ended March 31, 2000. Net cash used by 22 financing activities in the three months ended March 31, 2001 primarily reflects the repayment of long-term borrowings. Net cash provided by financing activities in the three months ended March 31, 2000 primarily consisted of net proceeds of $1.3 million from an equipment line of credit. During the first quarter of 2000, SmarterKids.com entered into a $1.5 million three-year equipment line of credit facility. Equipment collateralized under this agreement approximates $965,000 at March 31, 2001. The interest on the agreement is equal to the three-year U.S. Treasury rate plus 3.5%. SmarterKids.com is making payments on this credit facility of $45,000 per month. As of April 30, 2001, the balance of the equipment credit facility was paid in full. During the second quarter of 2000, SmarterKids.com entered into a lease agreement for a 140,000 square foot distribution center in Mansfield, Massachusetts. As a result, SmarterKids.com discontinued using J.L. Hammett Co. as its fulfillment partner during the second quarter of 2000. The five-year operating lease for the warehouse will require minimum payments of approximately $900,000 per year. The warehouse lease was terminated as of April 30, 2001 in connection with the restructuring plan extended in the first quarter of 2001. As of March 31, 2001, fulfillment services were outsourced to Earlychildhood. As of March 31, 2001, SmarterKids.com had $24.0 million of cash and cash equivalents and $1.1 million of short-term investments. As of that date, SmarterKids.com's principal commitments consisted of obligations outstanding under an equipment lines of credit and capital leases in the amount of $1.1 million, commitments for annual facility lease obligations of $3.0 million, and accounts payable of $2.7 million. SmarterKids.com anticipates that current cash, cash equivalents and short-term investments will be sufficient to meet its anticipated needs for working capital and capital expenditures through the next twelve months either on a stand-alone basis or in combination with Earlychildhood. Recent Accounting Pronouncements In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS No. 137, which was issued in June 2000. SmarterKids.com adopted SFAS No. 133 on January 1, 2001. SFAS No. 133 requires that all derivative instruments be reported on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. The adoption of SFAS No. 133 had no impact on SmarterKids.com's financial condition, results of operations, or business practices. 23 ITEM 6. EXHIBIT AND REPORTS ON FORM 8-K (a) Exhibit. The following Exhibit is filed herewith: Exhibit 99.1 Risk Factors (b) Reports on Form 8-K. None. 24 SIGNATURE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized in Monterey, California on the 15th day of May 2001. LEARNINGSTAR CORP. By: /s/ Robert J. Cahill -------------------------- Robert J. Cahill Chief Financial Officer (Duly Authorized Officer and Principal Financial Officer) 25 Exhibit Index to Report on Form 10-Q for Quarter Ended March 31, 2001 Exhibit No. Exhibit - ----------- ------- 99.1 Risk Factors 26 EX-99.1 2 dex991.txt RISK FACTORS Exhibit 99.1 RISK FACTORS Set forth below are the risk factors included in LearningStar's Registration Statement on Form S-4, as amended. Certain risk factors relating solely to the combination of Earlychildhood and SmarterKids.com have been omitted and certain other risk factors have been revised solely to reflect that the combination of Earlychildhood and SmarterKids.com has been consummated. The risk factors described below are not a comprehensive list of risk factors that apply to our business. Actual results could differ materially from those anticipated in the forward-looking statements contained in the Form 10-Q as a result of certain factors, including those set forth in the following risk factors and elsewhere in LearningStar's Registration Statement on Form S-4 and other reports on file with the Commission. WE MAY FAIL TO REALIZE THE ANTICIPATED BENEFITS OF THE COMBINATION OF EARLYCHILDHOOD AND SMARTERKIDS.COM, CAUSING OUR REVENUES AND MARKET PRICE TO DECLINE. We cannot assure you whether and to what extent the integration and consolidation of Earlychildhood and SmarterKids.com will be successfully implemented or will be able to achieve increased revenues, cost savings or operating synergies. The combination involves the integration of two companies that have previously operated independently. We cannot assure you that the respective operations of SmarterKids.com and Earlychildhood can be integrated without encountering difficulties. The success of the combination will depend, in large part, on the ability of SmarterKids.com, Earlychildhood and LearningStar to implement a strategic plan that will enable LearningStar to realize the anticipated growth opportunities and synergies from combining the business of SmarterKids.com with the business of Earlychildhood. If members of our management team are not able to develop strategies and implement a business plan that achieves these goals and the other objectives described below, the anticipated benefits of the combination may not be realized. In particular, anticipated growth in revenue, earnings before interest, taxes, depreciation and amortization, or "EBITDA," and cash flow may not be realized. Failure to realize these objectives could cause a decline in the market price of shares of our common stock and a continuation of operating losses at the combined company necessitating the implementation of significant employee cutbacks and other cost savings programs as we attempt to achieve long-term profitability. To realize the anticipated benefits of this combination, members of the our management team must develop strategies and implement a business plan that will achieve the following objectives: . effectively combine Earlychildhood's children's product catalog and school fund raising programs with SmarterKids.com's e-commerce technology and infrastructure; . successfully take advantage of the anticipated opportunities for cross- promoting and cross-selling Earlychildhood's and SmarterKids.com's products and services and for increasing revenues from the sale of products, services and information; . effectively and efficiently integrate SmarterKids.com's and Earlychildhood's policies, procedures, operations and employees; . successfully retain and attract key employees, including operating management and key technical personnel, during a period of transition and in light of the competitive employment market; and . while integrating Earlychildhood's and SmarterKids.com's operations and significant facilities, which are located in California, Florida, Georgia, Massachusetts, Pennsylvania and Texas, maintain adequate focus on the core businesses of the combined company in order to take advantage of competitive opportunities and to respond to competitive challenges. OUR COMMON STOCK MAY NOT ACHIEVE A VALUATION THAT FULLY REFLECTS THE TRUE VALUE OF THE COMBINED COMPANY. Shares of our common stock may not achieve a valuation on the public market that fully reflects the true value of the combined company, including its synergies and benefits. We are a provider of children's educational products and our business model includes both web-based and traditional catalog sales of products and services to the home and school markets. Financial analysts and investors may have difficulty identifying and applying measures of financial performance that reflect the value of the combined company. The market value of shares of common stock generally reflects a "multiple" of selected measures of financial performance, such as operating profits or earnings per share. The multiple for shares of our common stock may be based on the financial performance of SmarterKids.com, or it may be based on the financial performance of Earlychildhood, or it may reflect a "blending" of the two. The ultimate basis upon which the market values the combined entity's stock may not be indicative of our true value. THERE MAY BE SALES OF A SUBSTANTIAL AMOUNT OF OUR COMMON STOCK NOW THAT THE COMBINATION HAS BEEN COMPLETED, AND THESE SALES COULD CAUSE THE PRICE OF OUR COMMON STOCK TO DECLINE. After the expiration of 180 days from April 30, 2001 (or earlier pursuant to a waiver), the lock-up restrictions to which 6,402,583 shares of our common stock are subject will expire, and these shares may thereafter be sold. Sales of these shares could cause the price of our common stock to fall. In connection with the combination agreement, each of the directors and executive officers and certain significant stockholders of SmarterKids.com, as well as each of the members of the Earlychildhood management committee, each Earlychildhood executive officer and all holders of outstanding membership interests in Earlychildhood, entered into lock-up agreements with us. Pursuant to these lock-up agreements, all of the shares of our common stock received by these persons in connection with the combination may not be sold for a period of 180 days from April 30, 2001 without a waiver approved by us. It is conceivable that our board of directors may conclude that such a waiver might be in the best interests of the company and our stockholders as a means to enhance our public float in advance of the 180- day lock-up period and, in such case, some or all of these shares may be registered by us or otherwise permitted to be sold earlier than they would have been absent this waiver. Accordingly, investors considering a purchase of our common stock should not base their investment decision on the presumption that any or all of these shares will remain under lock-up for the full 180 days. A majority of the members of our board of directors or their affiliates are subject to such lock-up restrictions, and the interests of these members in obtaining earlier liquidity for their shares made possible by a waiver from the lock-up restrictions and registration by us may represent a conflict of interest for them. We presently anticipate that any waiver of lock-up restrictions pertaining to, and any registration of, a material number of shares (other than pursuant to the registration statement rights agreement) would be made pro rata for all stockholders subject to the lock-up restrictions and with advance notification to the market at large. Upon expiration of the lock-up agreements (or earlier pursuant to a waiver), these 6,402,583 securities may be sold in the future to the extent permitted under Rule 144, Rule 145 or another exemption under the Securities Act or upon the effectiveness of a resale registration statement with respect to these shares. Pursuant to the registration rights agreements, we have agreed to register under the Securities Act of 1933 up to an aggregate of 5,605,269 shares held by Earlychildhood members and 797,354 shares held by SmarterKids.com stockholders. The supply of our common stock created by sales pursuant to the expiration or waiver of the lock-up agreement and any registration effected by us in connection therewith, pursuant to registration of our common stock in accordance with the terms of the registration rights agreements or pursuant to Rule 144, Rule 145 or another permitted exemption under the Securities Act may cause the price of our common stock to decline. SMARTERKIDS.COM HAS INCURRED SIGNIFICANT OPERATING LOSSES TO DATE, AND FAILURE TO INCREASE SMARTERKIDS.COM'S REVENUES WHILE REDUCING OPERATING COSTS COULD PREVENT US FROM ACHIEVING PROFITABILITY. We need to generate greater revenues and operating profits while significantly reducing costs and operating expenses in order to achieve profitability. Earlychildhood incurred a pro forma net loss of $2.3 million for the twelve months ended December 31, 2000. SmarterKids.com incurred a net loss of $32.8 million for the twelve months ended December 31, 2000 and has not achieved profitability on a quarterly or annual basis. SmarterKids.com's revenues may not continue to grow and SmarterKids.com may never generate sufficient revenues to achieve profitability, which could negatively impact our results of operations. SmarterKids.com has incurred significant losses since its inception and may incur losses in the future. Continuing losses by SmarterKids.com or Earlychildhood could significantly reduce our ability to achieve profitability and result in a decline of our stock price. ADDITIONAL FINANCING MAY NOT BE AVAILABLE WHEN NEEDED OR MAY ONLY BE AVAILABLE ON TERMS THAT COULD RESULT IN HIGHER DEBT SERVICE COSTS FOR US, WHICH COULD CAUSE A REDUCTION IN OUR RESULTS OF OPERATIONS. If we are unable to negotiate borrowing arrangements that will permit us to meet our credit objectives, short-term revenue growth may be reduced and our long-term ability to meet our strategic objectives may be impaired. If cash from available sources is insufficient for our capital needs, we may need to raise additional capital. Additional financing, if needed, may not be available on satisfactory terms or at all. In addition, any additional issuance of equity or equity-related securities to raise capital would be dilutive to our existing stockholders. Any debt financing may also result in additional restrictions on our ability to pay dividends, which could cause our stock price to decline and restrictive covenants which could impair our ability to operate our business and fully implement our strategic plan. The businesses of SmarterKids.com and Earlychildhood are capital intensive. The integration and expansion of their businesses will require a significant commitment of resources, including, but not limited to, the expansion or addition of existing leased warehouse space and associated equipment, and additional hardware and software to expand internal networks and external Internet-based operations. Both businesses require significant levels of inventory leading up to their peak business periods, which we fund via a revolving line-of-credit. Our ability to fund our operations, make scheduled debt payments and planned capital expenditures and to remain in compliance with financial covenants under any credit facility will depend on their and our future operating performance and cash flow, which in turn, are subject to prevailing economic conditions and to financial, business and other factors, some of which are beyond our control. EACH OF SMARTERKIDS.COM'S AND EARLYCHILDHOOD'S BUSINESSES ARE HIGHLY SEASONAL, CAUSING EACH COMPANY TO BE OVERLY DEPENDENT ON A SINGLE QUARTER FOR ANNUAL REVENUES. Seasonal shopping patterns affect SmarterKids.com's business. A significant portion of SmarterKids.com's sales occurs in the fourth quarter, coinciding with the holiday shopping season. As such, SmarterKids.com's results of operations for the entire year depend largely on its fourth quarter results. Factors that could cause SmarterKids.com's sales and profitability to suffer include: . the availability of, and customer demand for, particular products; . unfavorable economic conditions, which decreases consumer confidence and lowers consumer discretionary spending; . the inability to hire adequate temporary personnel; . the inability to purchase or maintain appropriate inventory levels, which levels, if too low, could cause fulfillment delays of high demand product and, if too high, could leave SmarterKids.com with excess inventory of unpopular products; and . a late Thanksgiving, which reduces the number of shopping days between Thanksgiving and the holiday season. Earlychildhood's business is also subject to seasonality. A significant portion of Earlychildhood's sales occurs in the third quarter, coinciding with the start of the U.S. school year. As a result, Earlychildhood's results of operations for the entire year depend largely on its third quarter results. Factors that could cause Earlychildhood's sales and profitability to suffer include: . the availability of and customer demand for particular products; . unfavorable economic conditions, which decreases consumer confidence and lowers consumer discretionary spending; and . the inability to purchase or maintain appropriate inventory levels, which levels, if too low, could cause fulfillment delays of high demand product and, if too high, could leave SmarterKids.com with excess inventory of unpopular products. AFFILIATES OF EARLYCHILDHOOD HAVE SIGNIFICANT INFLUENCE OVER US, WHICH COULD LIMIT OUR OTHER STOCKHOLDERS' ABILITY TO INFLUENCE CORPORATE DECISIONS. Immediately after completion of the combination, two of the former largest holders of membership interests in Earlychildhood owned, in the aggregate, approximately 59.3% of our common stock on a fully-diluted basis. As a result, these stockholders, if they act together, will be able to control all matters requiring approval of a majority of our stockholders, including any merger, sale of assets and other significant corporate transactions. This control could: . delay or prevent a change of control of us; . deprive our stockholders of an opportunity to receive a premium for their common stock as a part of a sale of us or our assets; and . negatively affect the market price of our common stock. OUR OPERATIONS COULD BE DISRUPTED IF SMARTERKIDS.COM'S OR EARLYCHILDHOOD'S INFORMATION SYSTEMS FAIL INDEPENDENTLY OR AS PART OF THE INTEGRATION. Our success will be highly dependent upon the successful integration of each of SmarterKids.com's and Earlychildhood's hardware and software systems. Failure to successfully integrate these technologies could result in our operations being slowed or interrupted, reducing the performance of websites, fulfillment operations and customer service. Both SmarterKids.com's and Earlychildhood's businesses depend on the efficient and uninterrupted operation of their computer and communications software and hardware systems. Both companies regularly make investments to maintain, enhance and replace their individual systems. Each must assess and, if deemed necessary, appropriately expand the capacity of their information systems to accommodate the anticipated growth of the combined company or its operations could suffer. In addition, continued customer access to both SmarterKids.com's and Earlychildhood's websites is important to our success and the perception of our brand. Both websites may experience occasional system interruptions that make their website unavailable or prevent them from efficiently fulfilling orders. These interruptions may reduce the volume of goods sold, the attractiveness of products and services offered and damage Earlychildhood's, SmarterKid.com's and our reputation. Earlychildhood and SmarterKids.com may require additional software and hardware to upgrade the systems and network infrastructure of their websites to accommodate increased traffic and sales volume. Neither SmarterKids.com nor Earlychildhood can accurately project the rate or timing of any increases in traffic or sales volume on their individual websites and, therefore, the integration and timing of these upgrades are uncertain. Earlychildhood also depends heavily on software which is utilized in its order-taking, customer service, inventory management, and fulfillment operations. If problems with this software develop, Earlychildhood's operations could be slowed or interrupted, reducing the volume of goods sold and shipped and the attractiveness of products, services and information offered, causing damage to its reputation. Neither SmarterKids.com nor Earlychildhood have a formal recovery plan to prevent delays or other complications arising from information systems failure. Neither company's business interruption insurance may adequately compensate them for losses that may occur. WE ARE SUBJECT TO INTENSE COMPETITION WHICH MAY IMPEDE OR PREVENT US FROM ATTAINING GREATER MARKET SHARE AND COULD IMPAIR THE GROWTH OF OUR REVENUES. Intense competition and increased consolidation, which could result in one company's dominance in the marketplace, may result in loss of market share for us and ultimately reduce our revenues. Some of SmarterKids.com's direct competitors are specialty educational and creative toy and game retailers such as Zany Brainy and Learning Express. These retailers are continuing to expand and could impede SmarterKids.com's ability to increase its sales. SmarterKids.com is also subject to competition from mass market retailers and discounters such as Toys "R" Us, WalMart and Target which have greater brand recognition and greater financial, marketing and other resources than LearningStar. SmarterKids.com could be at a disadvantage in responding to these competitors' merchandising and pricing strategies, advertising campaigns and other initiatives. Several of these competitors, including Toys "R" Us, have launched successful Internet shopping sites that compete with SmarterKids.com and educational "boutique" areas within their retail sites. In addition, an increase in focus on the specialty retail market or the sale by these competitors of additional products similar to SmarterKids.com's could cause SmarterKids.com to lose market share. SmarterKids.com faces growing competition from Internet-only retailers, such as Amazon.com, which may have a cost advantage over SmarterKids.com and reach a broader market, as well as non-toy specialty retailers, which compete with SmarterKids.com's children's educational product business and could limit SmarterKids.com's ability to expand in these markets. SmarterKids.com's sales and profitability could suffer if: . new competitors enter markets in which SmarterKids.com is currently operating; . SmarterKids.com's competitors implement aggressive pricing strategies; . SmarterKids.com's competitors expand their operations; . SmarterKids.com's suppliers sell their products directly or enter into exclusive arrangements with SmarterKids.com's competitors; or . SmarterKids.com's competitors adopt innovative merchandising strategies that are similar to those of SmarterKids.com. Earlychildhood's direct competitors are educational supply companies such as School Specialty, Inc., Lakeshore Learning Materials, The Kaplan Companies, ABC School Supply, Inc., Beckley Cardy Co., U.S. Toy Company, Childcraft Education Corp., and J.L. Hammett Co.'s Earlychildhood Division. There has been consolidation among these competitors over the last several years; specifically, Beckley Cardy and Childcraft Education have all been purchased by School Specialty, Inc. Some of Earlychildhood's competitors, such as The Kaplan Companies and School Specialty, Inc. have launched successful websites which offer both products and information that compete with Earlychildhood's website. Earlychildhood manufactures products domestically and develops products internationally to offer low-cost, higher margin company-developed products. If one of its competitors pursued an aggressive manufacturing program, a competing line of similar company-developed products could cause Earlychildhood to lose market share. In addition, capital requirements in the school supply distribution industry are low, and there are few barriers to entry. A number of industry participants (including Discount School Supply and Educational Products, Inc.) have grown consistently, buoyed by strong industry fundamentals. Attracted by this growth, entrants could potentially re-create Earlychildhood's successful operating strategies, which could cause us to lose additional market share. Earlychildhood's sales and profitability could suffer if: . new competitors enter markets in which Earlychildhood is currently operating; . Earlychildhood's competitors implement aggressive pricing strategies; . Earlychildhood's competitors expand their operations; or . Earlychildhood's competitors recreate its operating strategies, specifically the importation and manufacture of company-developed products. IF OUR SUPPLIERS AND DISTRIBUTORS ALTER PURCHASING TERMS, OUR MARGINS AND PROFITABILITY WILL SUFFER. Many of our suppliers provide us with incentives, such as return privileges, volume purchasing allowances and cooperative advertising. A reduction or discontinuation of these incentives could increase costs and decrease our margins and profitability. IF A SHIPMENT OF PRODUCTS THAT WE IMPORT IS INTERRUPTED OR DELAYED, OUR INVENTORY LEVELS AND SALES COULD DECLINE. We import some of our product offerings from foreign manufacturers. These foreign manufacturers are located in countries such as Japan, China, Taiwan, Germany and South Korea, among others. We are subject to the following risks inherent in relying on foreign manufacturers: . the inability to return products which could result in excess inventory; . fluctuations in currency exchange rates which could potentially result in a weaker U.S. dollar in overseas markets, increasing the cost of inventory purchased; . transportation delays and trade restrictive actions by foreign governments which could result in delays in shipping products to our customers; . the laws and policies of the United States affecting importation of goods, including duties, quotas and taxes and; . trade infringement claims. Interruptions or delays in our imports could cause shortages in product inventory and a decline in our sales unless we secure alternative supply arrangements. Even if we could locate alternative sources, these alternative products may be of lesser quality or more expensive. Our sales could also suffer if our suppliers experience similar problems with foreign manufacturers. WE MAY BE EXPOSED TO PRODUCT LIABILITY LAWSUITS AND OTHER CLAIMS IF WE FAIL TO COMPLY WITH GOVERNMENT AND TOY INDUSTRY SAFETY STANDARDS. Children can sustain injuries from toys and other educational products. Each of SmarterKids.com, Earlychildhood and LearningStar may be subject to claims or lawsuits resulting from such injuries. There is a risk that claims or liabilities may exceed all of SmarterKids.com's, Earlychildhood's and LearningStar's insurance coverage. Moreover, each of SmarterKids.com, Earlychildhood and LearningStar may be unable to retain adequate liability insurance in the future. SmarterKids.com, Earlychildhood and LearningStar are also subject to regulation by the Consumer Product Safety Commission and similar state regulatory authorities and our products could be subject to recalls and other actions by such authorities. WE MAY BE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, WHICH COULD IMPAIR BRAND AND REPUTATION. Efforts by SmarterKids.com, Earlychildhood and LearningStar to protect our proprietary rights may be inadequate. Each company regards its intellectual property as important to the marketing strategy of the combined company. To protect our proprietary rights, SmarterKids.com, Earlychildhood and LearningStar generally rely on copyright, trademark and trade secret laws, confidentiality agreements with employees and third parties and license agreements with consultants and suppliers. However, a third party could, without authorization, copy or otherwise appropriate information from any of the companies. Furthermore, with respect to Earlychildhood, whose trademark in Earlychildhood.com is a descriptive mark that has not been and likely will not be registered with the United States Patent and Trademark Office, third parties may use marks similar to Earlychildhood's, potentially diminishing Earlychildhood's brand name and reputation. Employees, consultants and others who participate in development activities could breach their confidentiality agreements, and we may not have adequate remedies for any such breach. Our failure or inability to protect our proprietary rights could materially decrease our value, and each company's individual, as well as our combined, brand and reputation could be impaired. THE COST OF MATERIALS USED TO MANUFACTURE PRODUCTS IS SUBJECT TO VOLATILITY, WHICH COULD REDUCE OUR PROFITABILITY. The unavailability of raw materials or a substantial increase in their prices could reduce our profitability and have a negative impact on our stock price. Currently, Earlychildhood manufactures certain products, including non-toxic tempera paints, finger paints, glues and other water-based art mediums. Earlychildhood may, from time to time, experience difficulty in obtaining adequate raw material requirements at competitive prices, and experience shortages of raw materials used in its manufacturing process. EARLYCHILDHOOD IS SUBJECT TO REGULATION BY FEDERAL AND STATE ENVIRONMENTAL AUTHORITIES AND MAY BE SUBJECT TO ENVIRONMENTAL CLAIMS RELATING TO ITS MANUFACTURING PROCESSES. If Earlychildhood fails to comply with environmental laws and regulations, it may incur material liabilities in the form of administrative, civil, or criminal enforcement by government agencies or other parties, which would reduce our profitability and cause our stock price to decline. Earlychildhood's manufacturing operations are subject to numerous federal, state, and local environmental and occupational health and safety laws and regulations, which include laws and regulations governing waste disposal, air and water emissions, the handling of hazardous substances, workplace exposure, and other matters. Although at this time neither we nor Earlychildhood is required to make any material capital expenditures, in the future, we and/or Earlychildhood may be required to make material capital expenditures to remain in compliance with applicable environmental laws and regulations. In the future, we or Earlychildhood may also be required to make expenditures to maintain environmental control systems, to remedy spills or leaks of toxic materials stored in its facilities, or to dispose of hazardous materials like batteries required in its manufacturing process. Such expenditures could reduce our profitability. In addition, the adoption of new environmental laws and regulations, changes in existing laws and regulations, or their interpretation, stricter enforcement of existing laws and regulations, or governmental or private claims for damage to persons, property, or the environment resulting from our business may force us to expend additional capital and resources on environmental compliance. PROVISIONS OF OUR CHARTER AND BYLAWS AND DELAWARE LAW MAY HAVE ANTI-TAKEOVER EFFECTS THAT COULD PREVENT A CHANGE IN CONTROL OF LEARNINGSTAR. Certain provisions of the our restated certificate of incorporation and amended and restated bylaws and Delaware law may have the effect of delaying or preventing a change of control of LearningStar and, therefore, could cause the price of our common stock to decline. Our restated certificate of incorporation authorizes our board of directors to issue, without shareholder approval, shares of preferred stock with voting, conversion and other rights and preferences that could adversely affect the voting power or other rights of the holders of our common stock. The issuance of preferred stock or of rights to purchase preferred stock could be used to discourage an unsolicited acquisition proposal. In addition, the possible issuance of preferred stock could discourage a proxy contest, make more difficult the acquisition of a substantial block of our common stock or limit the price that investors might be willing to pay in the future for shares of our common stock. Our restated certificate of incorporation and amended and restated bylaws also provide that: . our board of directors may adopt, amend or repeal the bylaws or any provision of our restated certificate of incorporation, however, the affirmative vote of the holders of at least 75% of the voting power of all outstanding shares of our capital stock voting as a single class is required to adopt, amend or repeal the amended and restated bylaws or any provision of our restated certificate of incorporation or; . our stockholders may not take any action by written consent; . special meetings of our stockholders may be called only by the chairman of the board of directors or a majority of our board of directors and business transacted at any special meeting shall be limited to matters relating to the purposes set forth in the notice of the special meeting; and . our board of directors will be divided into three classes serving staggered three-year terms. In addition, we are subject to certain "anti-takeover" provisions of the Delaware General Corporation Law which, subject to certain exceptions, restrict certain transactions and business combinations between a corporation and a shareholder owning 15% or more of the corporation's outstanding voting stock (an "interested shareholder") for a period of three years from the date the shareholder becomes an interested shareholder. THE IMPOSITION OF STATE SALES TAX AND OTHER TAX OBLIGATIONS ON E-COMMERCE COULD CAUSE OUR REVENUES TO DECREASE AND LIMIT SMARTERKIDS.COM'S AND EARLYCHILDHOOD'S GROWTH. The broader imposition of sales and use tax collection responsibilities on LearningStar, Earlychildhood or SmarterKids.com would increase the direct cost to customers of our products, as well as increase the administrative and overhead costs associated with the collection and payment of these taxes. Our competitive position could be weakened relative to local competitors who are already subject to these tax collection requirements and non-local competitors who might still be free of these requirements. Neither SmarterKids.com nor Earlychildhood currently collects state sales and use taxes or other similar taxes with respect to its marketing of products to customers in states where it does not have a tax "nexus." It is possible that potential changes in the way that SmarterKids.com and Earlychildhood do business after the combination could result in LearningStar being more broadly subject to sales and use tax collection responsibilities or to state income taxes which could reduce our revenues or profits. A number of proposals have been made at the federal, state, local and international levels that would impose taxes on the sale of goods and services through the Internet in circumstances where no tax or tax collection responsibility is presently thought to be imposed. These proposals, if adopted, could substantially impair the growth of e-commerce and our business prospects and growth. Any or all of these potential changes and developments, either in the combined companies' methods of operations or the tax rules that govern them, could diminish the combined companies' revenues and future results of operations and weaken its financial condition. In addition, there is currently in effect in the United States a three-year moratorium expiring on October 20, 2001 on new state and local taxes on Internet access and "multiple or discriminatory" taxes on e-commerce. Sales or use taxes imposed on those buying or selling products or services over the Internet are not generally affected by this moratorium. The full effect of this moratorium on our business is not clear. To the extent that the moratorium provides a material benefit, its expiration on October 20, 2001 could reduce our revenues and results of operations and weaken our financial condition. -----END PRIVACY-ENHANCED MESSAGE-----