10-Q 1 g76332e10-q.txt GRAY COMMUNICATIONS SYSTEMS, INC. UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2002. OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _________ TO _________ . COMMISSION FILE NUMBER 1-13796 GRAY COMMUNICATIONS SYSTEMS, INC. ------------------------------------------------------------------------ (Exact name of registrant as specified in its charter) GEORGIA 58-0285030 -------------------------------- --------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 4370 PEACHTREE ROAD, NE, ATLANTA, GEORGIA 30319 ------------------------------------------------------------------------ (Address of principal executive offices) (Zip code) (404) 504-9828 ------------------------------------------------------------------------ (Registrant's telephone number, including area code) NOT APPLICABLE ------------------------------------------------------------------------ (Former name, former address and former fiscal year, if changed since last report.) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date.
CLASS A COMMON STOCK, (NO PAR VALUE) CLASS B COMMON STOCK, (NO PAR VALUE) ------------------------------------------------ ------------------------------------------- 6,848,467 SHARES AS OF MAY 14, 2002 8,813,017 SHARES AS OF MAY 14, 2002
INDEX GRAY COMMUNICATIONS SYSTEMS, INC.
PAGE ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed consolidated balance sheets - March 31, 2002 (Unaudited) and December 31, 2001 3 Condensed consolidated statements of operations (Unaudited) -- Three months ended March 31, 2002 and 2001 5 Condensed consolidated statement of stockholders' equity (Unaudited) -- Three months ended March 31, 2002 6 Condensed consolidated statements of cash flows (Unaudited) -- Three months ended March 31, 2002 and 2001 7 Notes to condensed consolidated financial statements (Unaudited) -- March 31, 2002 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 14 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K 21 SIGNATURES 22
2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS GRAY COMMUNICATIONS SYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS
MARCH 31, DECEMBER 31, 2002 2001 ------------- ------------- (UNAUDITED) ASSETS: Current assets: Cash and cash equivalents $ 3,165,379 $ 557,521 Restricted cash for redemption of long-term debt -0- 168,557,417 Trade accounts receivable, less allowance for doubtful accounts of $649,000 and $743,000, respectively 24,926,846 29,722,141 Recoverable income taxes 987,331 552,177 Inventories 969,943 763,430 Current portion of program broadcast rights 2,564,406 3,809,238 Other current assets 991,862 742,150 ------------- ------------- Total current assets 33,605,767 204,704,074 ------------- ------------- Property and equipment: Land 4,899,829 4,905,121 Buildings and improvements 16,932,194 16,904,976 Equipment 114,543,965 113,018,560 ------------- ------------- 136,375,988 134,828,657 Allowance for depreciation (75,003,348) (71,412,314) ------------- ------------- 61,372,640 63,416,343 Deferred loan costs, net 11,333,958 14,305,495 Licenses and network affiliation agreements 403,794,201 424,384,811 Goodwill 53,150,505 72,025,145 Consulting and noncompete agreements 794,814 901,216 Other 14,549,503 14,599,894 ------------- ------------- $ 578,601,388 $ 794,336,978 ============= =============
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS. 3 GRAY COMMUNICATIONS SYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (CONTINUED)
MARCH 31, DECEMBER 31, 2002 2001 ------------- ------------- (UNAUDITED) LIABILITIES AND STOCKHOLDERS' EQUITY: Current liabilities: Trade accounts payable $ 3,798,498 $ 7,632,778 Employee compensation and benefits 5,985,619 6,002,892 Accrued expenses 1,857,252 1,588,302 Accrued interest 7,669,877 7,872,585 Current portion of program broadcast obligations 2,393,229 3,655,881 Deferred revenue 3,278,279 2,783,069 Unrealized loss on derivatives 1,192,000 1,581,000 Current portion of long-term debt 456,000 155,262,277 ------------- ------------- Total current liabilities 26,630,754 186,378,784 Long-term debt, less current portion 390,992,008 396,182,025 Program broadcast obligations, less current portion 575,890 619,320 Supplemental employee benefits 472,082 397,720 Deferred income taxes 54,357,563 66,790,563 Other 1,695,424 1,772,989 ------------- ------------- 474,723,721 652,141,401 ------------- ------------- Commitments and contingencies Stockholders' equity: Serial Preferred Stock, no par value; authorized 20,000,000 shares; issued and outstanding 861 shares, respectively ($8,605,788 aggregate liquidation value, respectively) 4,636,663 4,636,663 Class A Common Stock, no par value; authorized 15,000,000 shares; issued 7,961,574 shares, respectively 20,172,959 20,172,959 Class B Common Stock, no par value; authorized 15,000,000 shares; issued 8,808,552 and 8,792,227 shares, respectively 117,828,691 117,634,928 Retained earnings (30,421,928) 8,089,745 ------------- ------------- 112,216,385 150,534,295 Treasury Stock at cost, Class A Common Stock, 1,113,107 shares, respectively (8,338,718) (8,338,718) ------------- ------------- 103,877,667 142,195,577 $ 578,601,388 $ 794,336,978 ============= =============
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS. 4 GRAY COMMUNICATIONS SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
THREE MONTHS ENDED MARCH 31, ----------------------------------- 2002 2001 ------------- ------------- Operating revenues: Broadcasting (net of agency commissions) $ 25,452,470 $ 25,042,113 Publishing 10,143,051 9,739,846 Paging 2,009,245 2,146,610 ------------- ------------- 37,604,766 36,928,569 ------------- ------------- Expenses: Broadcasting 15,481,312 16,307,988 Publishing 7,650,608 7,902,104 Paging 1,383,020 1,435,663 Corporate and administrative 1,000,026 944,407 Depreciation and amortization 3,733,003 7,850,672 ------------- ------------- 29,247,969 34,440,834 ------------- ------------- Operating income 8,356,797 2,487,735 Miscellaneous income, net 37,936 70,933 Appreciation (depreciation) in value of derivatives, net 389,000 (785,442) ------------- ------------- 8,783,733 1,773,226 Interest expense 8,964,710 9,250,952 ------------- ------------- LOSS BEFORE INCOME TAXES, EXTRAORDINARY CHARGE AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE (180,977) (7,477,726) Income tax benefit (45,800) (2,450,000) ------------- ------------- NET LOSS BEFORE EXTRAORDINARY CHARGE AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE (135,177) (5,027,726) Extraordinary charge on extinguishment of debt, net of income tax benefit of $3,957,800 (7,317,517) -0- ------------- ------------- NET LOSS BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE (7,452,694) (5,027,726) Cumulative effect of accounting change, net of income tax benefit of $8,873,400 (30,591,800) -0- NET LOSS (38,044,494) (5,027,726) Preferred dividends 154,087 154,087 ------------- ------------- NET LOSS AVAILABLE TO COMMON STOCKHOLDERS $ (38,198,581) $ (5,181,813) ============= ============= Basic and diluted per share information: Net loss before extraordinary charge and cumulative effect of accounting change $ (0.01) $ (0.32) Extraordinary charge on extinguishment of debt, net of income tax benefit (0.47) (0.00) Cumulative effect of accounting change, net of income tax benefit (1.95) (0.00) Preferred dividends (0.01) (0.01) ------------- ------------- Net loss available to common stockholders $ (2.44) $ (0.33) ============= ============= Weighted average shares outstanding 15,646,712 15,571,473 ============= =============
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS. 5 GRAY COMMUNICATIONS SYSTEMS, INC. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (UNAUDITED)
CLASS A CLASS B PREFERRED STOCK COMMON STOCK COMMON STOCK ------------------ ------------------------ ------------------------ RETAINED SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT EARNINGS ------ ---------- --------- ----------- --------- ------------ ------------ Balance at December 31, 2001 861 $4,636,663 7,961,574 $20,172,959 8,792,227 $117,634,928 8,089,745 Net loss for the three months ended March 31, 2002 -0- -0- -0- -0- -0- -0- (38,044,494) Common Stock cash dividends ($0.02) per share -0- -0- -0- -0- -0- -0- (313,092) Preferred Stock dividends -0- -0- -0- -0- -0- -0- (154,087) Issuance of Common Stock: 401(k) plan -0- -0- -0- -0- 16,325 193,763 -0- --- ---------- --------- ----------- --------- ------------ ------------ Balance at March 31, 2002 861 $4,636,663 7,961,574 $20,172,959 8,808,552 $117,828,691 $(30,421,928) === ========== ========= =========== ========= ============ ============ CLASS A TREASURY STOCK -------------------------- SHARES AMOUNT TOTAL ---------- ----------- ------------ Balance at December 31, 2001 (1,113,107) $(8,338,718) $142,195,577 Net loss for the three months ended March 31, 2002 -0- -0- (38,044,494) Common Stock cash dividends ($0.02) per share -0- -0- (313,092) Preferred Stock dividends -0- -0- (154,087) Issuance of Common Stock: 401(k) plan -0- -0- 193,763 ---------- ----------- ------------ Balance at March 31, 2002 (1,113,107) $(8,338,718) $103,877,667 ========== =========== ============
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS. 6 GRAY COMMUNICATIONS SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
THREE MONTHS ENDED MARCH 31, ----------------------------------- 2002 2001 ------------- ------------- Operating activities Net loss $ (38,044,494) $ (5,027,726) Adjustments to reconcile net loss to net cash provided by operating activities: Cumulative effect of accounting change 30,591,800 -0- Amortization of bond discount 36,045 -0- Depreciation 3,626,823 4,270,780 Amortization of intangible assets 106,180 3,579,892 Amortization of deferred loan costs 352,231 385,491 Amortization of program broadcast rights 1,320,461 1,352,940 Write-off of loan acquisition costs related to debt extinguished 3,030,266 -0- Payments for program broadcast rights (1,321,567) (1,352,820) Supplemental employee benefits (22,661) (82,548) Common stock contributed to 401(k) Plan 193,763 203,768 (Appreciation) depreciation in value of derivatives, net (389,000) 785,442 Deferred income taxes (3,559,550) (2,552,000) Gain on disposal of assets (15,715) (15,786) Changes in operating assets and liabilities: Receivables, inventories and other current assets 3,903,916 5,472,603 Accounts payable and other current liabilities 457,038 (664,266) ------------- ------------- Net cash provided by operating activities 265,536 6,355,770 Investing activities Restricted cash for redemption of long-term debt 168,557,417 -0- Purchases of property and equipment (5,243,855) (675,960) Other (60,762) 30,094 ------------- ------------- Net cash provided by (used in) investing activities 163,252,800 (645,866) Financing activities Dividends paid (467,179) (465,991) Deferred loan costs (410,960) -0- Proceeds from issuance of common stock -0- 519,858 Proceeds from sale of treasury stock -0- 166,917 Proceeds from borrowings of long-term debt 5,272,346 4,950,000 Payments on long-term debt (165,304,685) (11,990,940) ------------- ------------- Net cash used in financing activities (160,910,478) (6,820,156) ------------- ------------- Increase (decrease) in cash and cash equivalents 2,607,858 (1,110,252) Cash and cash equivalents at beginning of period 557,521 2,214,838 ------------- ------------- Cash and cash equivalents at end of period $ 3,165,379 $ 1,104,586 ============= =============
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS. 7 NOTE A--BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements of Gray Communications Systems, Inc. (the "Company") have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three-month period ended March 31, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2001. Accounting for Derivatives On January 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and for Hedging Activities," as amended ("SFAS 133"). SFAS 133 provides a comprehensive standard for the recognition and measurement of derivatives and hedging activities. SFAS 133 requires all derivatives to be recorded on the balance sheet at fair value and establishes "special accounting" for the different types of hedges. Changes in the fair value of derivatives that do not meet the hedged criteria are included in earnings in the same period of the change. In 1999, the Company entered into an interest rate swap agreement that is designated as a hedge against fluctuations in interest expense resulting from a portion of its variable rate debt. Due to the terms of the interest rate swap agreement, it does not qualify for hedge accounting under SFAS 133. Therefore, the changes in the fair value of the interest rate swap agreement are recorded in the Company's earnings as income or expense in the period in which the change in value occurs. During the three months ended March 31, 2002, the estimated liability associated with the interest rate swap agreement decreased and the Company recognized appreciation in the value of its derivative of $389,000. As a result of the adoption of SFAS 133 and the general decrease in market interest rates during the quarter ended March 31, 2001, the estimated liability associated with the interest rate swap agreement increased and the Company recognized depreciation in the value of its derivative of $785,442. Earnings Per Share The Company computes earnings per share in accordance with Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("EPS"). The weighted average number of shares used in computing basic and diluted loss per share was 15,646,712, and 15,571,473 in the three month periods ended March 31, 2002 and 2001, respectively. Dilutive securities of 230,487 and 790,961 are not included in the calculation of diluted EPS in the three month periods ending March 31, 2002 and 2001, respectively, because these securities would have an antidilutive effect. Implementation of New Accounting Principle In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, "Business Combinations" and No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). These standards change the accounting for business combinations by, among other things, prohibiting the prospective use of pooling-of-interests accounting and requiring companies to stop amortizing goodwill and certain intangible assets with an indefinite useful life. Instead, goodwill and intangible assets deemed to have an indefinite useful life will be subject to an annual review for impairment. The new standards were effective for the Company on January 1, 2002. Upon adoption of SFAS 142, the Company recorded a one-time, non-cash charge of approximately $39.5 million ($30.6 million after income taxes) to reduce the carrying value of its goodwill, licenses and network affiliation agreements. Such charge is reflected as a cumulative effect of an accounting change in the accompanying condensed consolidated statement of operations. For additional discussion on the impact of adopting SFAS 142, see Note D. NOTE A--BASIS OF PRESENTATION (CONTINUED) Reclassifications 8 Certain prior year amounts in the accompanying condensed consolidated financial statements have been reclassified to conform with the 2002 presentation. NOTE B--BUSINESS ACQUISITION On April 1, 2002, the Company entered into a Letter of Intent to acquire Stations Holding Company, Inc., the parent company of Benedek Broadcasting Corporation ("Benedek") in a transaction valued at approximately $500 million. The acquisition is subject to execution of a definitive agreement, which the companies expect to execute soon, as well as approval by the Federal Communications Commission of the transfer of control of Benedek's television licenses. The transaction is also subject to approval of the Delaware bankruptcy court with jurisdiction over the reorganization of Stations Holding Company, Inc. Management continues to believe that the transaction will close by the fourth quarter of 2002. The Company intends to finance the acquisition by issuing a combination of debt and equity securities. The Company is considering, among other alternatives, raising the equity financing through a secondary public offering of the Company's Common Stock. NOTE C--LONG-TERM DEBT On December 21, 2001, the Company completed its sale of $180 million aggregate principal amount of Senior Subordinated Notes due 2011 (the "9 1/4% Notes"). On this same date, the Company instructed the trustee for the 10 5/8% Senior Subordinated Notes (the "10 5/8% Notes") to commence the redemption, in full, of the remaining 10 5/8% Notes outstanding. Gray deposited cash of approximately $168.6 million with the 10 5/8% Notes' trustee, to redeem the aggregate principal amount of the 10 5/8% Notes outstanding of $155.2 million and to fund associated premium costs of $8.2 million, accrued interest of $3.7 million and certain other related expenses of $1.5 million. This cash was funded from the net proceeds of the 9 1/4% Notes and was included in the consolidated balance sheet at December 31, 2001 as "restricted cash for redemption of long-term debt". The redemption was completed on January 22, 2002 and all obligations associated with the 10 5/8% Notes as well as the rights associated with the restricted cash were extinguished on that date. The Company recorded an extraordinary charge of approximately $11.3 million ($7.3 million after income tax) in the quarter ended March 31, 2002 in connection with this early extinguishment of debt. At March 31, 2002, the balance outstanding and the balance available under the Company's bank loan agreement were $212.5 million and $37.5 million, respectively, and the interest rate on the balance outstanding was 5.3%. NOTE D--GOODWILL AND INTANGIBLE ASSETS As discussed in Note A, in January 2002, the Company adopted SFAS 142, which requires companies to discontinue amortizing goodwill and certain intangible assets with indefinite useful lives. Instead, SFAS 142 requires that goodwill and intangible assets deemed to have an indefinite useful life be reviewed for impairment upon adoption of SFAS 142 and annually thereafter. The Company will perform its annual impairment review during the fourth quarter of each year, commencing in the fourth quarter of 2002. Other intangible assets will continue to be amortized over their useful lives. Under SFAS 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. As of January 1, 2002, the Company performed the first of the required impairment tests of goodwill and indefinite lived intangible assets. Under SFAS 142, the annual impairment tests are performed at the lowest level for which there are identifiable cash flows. As a result of implementing SFAS 142 and the required impairment tests at January 1, 2002, the Company recognized a non-cash impairment of goodwill and other NOTE D--GOODWILL AND INTANGIBLE ASSETS (CONTINUED) intangible assets of $39.5 million ($30.6 million net of income taxes). Such charge is reflected as a cumulative effect of an accounting change in the accompanying condensed consolidated statement of operations. In calculating the impairment charge, the fair value of the reporting units underlying the segments were estimated using a discounted cash flow methodology. 9 The Company expects to receive future benefits from previously acquired goodwill and licenses over an indefinite period of time. Upon adoption of SFAS 142 on January 1, 2002, the Company stopped amortizing these assets. Amortization of these assets totaled $3.5 million ($2.6 million after income taxes) for the quarter ended March 31, 2001. A summary of changes in the Company's goodwill and other intangible assets during the quarter ended March 31, 2002, by business segment is as follows (in thousands):
DECEMBER 31, MARCH 31, 2001 IMPAIRMENTS AMORTIZATION 2002 ------------ ----------- ------------ -------- Goodwill: Broadcasting $ 55,241 $(18,874) $ -0- $ 36,367 Publishing 16,779 -0- -0- 16,779 Paging 5 -0- -0- 5 --------- -------- ----- -------- $ 72,025 $(18,874) $ -0- $ 53,151 ========= ======== ======== ======== Licenses and network affiliation agreements: Broadcasting $ 407,592 $(10,291) $ -0- $397,301 Paging 16,793 (10,300) -0- 6,493 --------- -------- ----- -------- $ 424,385 $(20,591) $ -0- $403,794 ========= ======== ===== ======== Consulting and noncompete agreements: Publishing $ 901 $ -0- $(106) $ 795 ========= ======== ===== ======== Total intangible assets net of accumulated amortization $ 497,311 $(39,465) $(106) $457,740 ========= ======== ===== ========
As of March 31, 2002 and December 31, 2001, the Company's intangible assets and related accumulated amortization consisted of the following (in thousands):
AS OF MARCH 31, 2002 AS OF DECEMBER 31, 2001 -------------------------------------------- -------------------------------------------- ACCUMULATED ACCUMULATED GROSS AMORTIZATION NET GROSS AMORTIZATION NET --------- ------------ -------- --------- ------------ -------- Intangible assets not subject to amortization: Licenses and network affiliation agreements $ 454,246 $ (50,452) $403,794 $ 474,836 $ (50,451) $424,385 Goodwill 59,441 (6,290) 53,151 78,315 (6,290) 72,025 --------- --------- -------- --------- --------- -------- $ 513,687 $ (56,742) $456,945 $ 553,151 $ (56,741) $496,410 ========= ========= ======== ========= ========= ======== Intangible assets subject to amortization: Consulting and noncompete agreements $ 3,105 $ (2,310) $ 795 $ 3,105 $ (2,204) $ 901 ========= ========= ======== ========= ========= ======== Total intangibles $ 516,792 $ (59,052) $457,740 $ 556,256 $ (58,945) $497,311 ========= ========= ======== ========= ========= ========
NOTE D--GOODWILL AND INTANGIBLE ASSETS (CONTINUED) The Company recorded amortization expense of $106,000 during the first quarter of 2002 compared to $122,000 on a pro forma basis during the first quarter of 2001. Based on the current amount of intangible assets subject to amortization, the estimated amortization expense for the succeeding 5 years are as follows: 2002: $426,607; 2003: $425,600; and 2004: $50,000. As acquisitions and dispositions occur in the future, these amounts may vary. 10 The results for the quarter ended March 31, 2001 on a historical basis do not reflect the provisions of SFAS 142. Had the Company adopted SFAS 142 on January 1, 2001, the historical amounts would have been changed to the adjusted amounts as indicated in the table below (in thousands except per share data):
THREE MONTHS ENDED MARCH 31, --------------------------- 2002 2001 --------- --------- Reported net loss before extraordinary charge and cumulative effect of accounting change $ (135) $ (5,028) Elimination of amortization of goodwill, net of income tax -0- 437 Elimination of amortization of licenses and network affiliation agreements, net of income tax -0- 2,190 --------- --------- Adjusted net loss before extraordinary charge and cumulative effect of accounting change $ (135) $ (2,401) ========= ========= Basic and diluted per share information: Net loss before extraordinary charge and cumulative effect of accounting change (0.01) (0.32) Elimination of amortization of goodwill, net of income tax (0.00) 0.03 Elimination of amortization of licenses and network affiliation agreements, net of income tax (0.00) 0.14 --------- --------- Adjusted net loss before extraordinary charge and cumulative effect of accounting change $ (0.01) $ (0.15) ========= =========
NOTE E--INFORMATION ON BUSINESS SEGMENTS The Company operates in three business segments: broadcasting, publishing and paging. The broadcasting segment operates 13 television stations located in the southern and mid-western United States. The publishing segment operates four daily newspapers located in Georgia and Indiana. The paging operations are located in Florida, Georgia and Alabama. The following tables present certain financial information concerning the Company's three operating segments (in thousands):
THREE MONTHS ENDED MARCH 31, ------------------------ 2002 2001 -------- -------- Operating revenues: Broadcasting $ 25,453 $ 25,042 Publishing 10,143 9,740 Paging 2,009 2,147 -------- -------- $ 37,605 $ 36,929 ======== ========
NOTE E--INFORMATION ON BUSINESS SEGMENTS (CONTINUED)
THREE MONTHS ENDED MARCH 31, ------------------------ 2002 2001 -------- -------- Operating income: Broadcasting $ 6,270 $ 1,369 Publishing 1,785 969 Paging 302 150 -------- -------- Total operating income 8,357 2,488
11 Miscellaneous income, net 38 71 Appreciation (depreciation) in value of derivatives, net 389 (786) Interest expense (8,965) (9,251) Loss before income taxes $ (181) $ (7,478) ======== ======== Media Cash Flow: Broadcasting $ 10,101 $ 8,875 Publishing 2,535 1,877 Paging 638 723 -------- -------- $ 13,274 $ 11,475 ======== ======== Media Cash Flow reconciliation: Operating income $ 8,357 $ 2,488 Add: Amortization of program broadcast rights 1,321 1,353 Depreciation and amortization 3,733 7,851 Corporate overhead 1,000 944 Non-cash compensation and contributions to the Company's 401(k) plan, paid in common stock 185 192 Less: Payments for program broadcast obligations (1,322) (1,353) -------- -------- Media Cash Flow $ 13,274 $ 11,475 ======== ========
Operating income is total operating revenues less operating expenses, excluding miscellaneous income and expense (net), appreciation (depreciation)in value of derivatives, net and interest. Corporate and administrative expenses are allocated to operating income based on net segment revenues. NOTE F--PREFERRED STOCK On April 22, 2002, the Company issued $40 million (4,000 shares) of redeemable and convertible preferred stock to a group of private investors. The preferred stock was designated as Series C Preferred Stock and has a liquidation value of $10,000 per share. The Series C Preferred Stock is convertible into the Company's Class B Common Stock at a conversion price of $14.39 per share. The Series C Preferred Stock will be redeemable at the Company's option on or after April 22, 2007 and will be subject to mandatory redemption on April 22, 2012 at liquidation value. Dividends on the Series C Preferred Stock will accrue at 8% per annum until April 22, 2009 after which the dividend rate shall be 8.5% per annum. Dividends, when declared by the Company's board of directors may be paid at the Company's option in cash or additional shares of Series C Preferred Stock. As part of the transaction, holders of the Company's Series A and Series B Preferred Stock have exchanged all of the outstanding shares of each respective series, an aggregate fair value of approximately $8.6 million, for an equal number of shares of the Series C Preferred Stock. The excess of the $8.6 million price to redeem the Series A NOTE F--PREFERRED STOCK (CONTINUED) and Series B Preferred Stock over its carrying value of $4.6 million was charged to retained earnings upon redemption in April 2002. Upon closing this transaction, the Series C Preferred Stock is the only currently outstanding preferred stock of the Company. Net cash proceeds approximated $30.5 million, after transaction fees and expenses and excluding the value of the Series A and Series B Preferred Stock exchanged into the Series C Preferred Stock. The Company used the net cash proceeds to repay all current outstanding borrowings of $13.5 million under the Company's revolving credit facility and intends to use the remaining net cash proceeds for other general corporate purposes. NOTE G--INCOME TAXES 12 The Internal Revenue Service (the "IRS") is auditing the Company's federal tax return for the year ended December 31, 1996. In conjunction with this examination, the Company extended the time period that the IRS has to audit the Company's federal tax returns for the 1996 and 1997 tax years until December 31, 2001. In October 2001, the Company received a notice of deficiency from the IRS associated with its audit of the Company's 1996 federal income tax return. The IRS alleges in the notice that the Company owes approximately $12.1 million of tax plus interest and penalties stemming from certain acquisition related transactions, which occurred in 1996. Additionally, if the IRS were successful in its claims, the Company would be required to account for these acquisition transactions as stock purchases instead of asset purchases which would significantly lower the tax basis in the assets acquired. The Company believes the IRS claims are without merit and on January 18, 2002 filed a petition to contest the matter in United States Tax Court. The Company cannot predict when the tax court will conclude its ruling on this matter. 13 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Introduction The following analysis of the financial condition and results of operations of Gray Communications Systems, Inc. (the "Company") should be read in conjunction with the Company's unaudited Condensed Consolidated Financial Statements and notes thereto included elsewhere herein. General Broadcast advertising revenues are generally highest in the second and fourth quarters each year, due in part to increases in consumer advertising in the spring and retail advertising in the period leading up to and including the holiday season. In addition, broadcast advertising revenues are generally higher during even numbered election years due to spending by political candidates and other political advocacy groups, which spending typically is heaviest during the fourth quarter. Broadcasting, Publishing and Paging Revenues Set forth below are the principal types of broadcasting, publishing and paging revenues earned by the Company's broadcasting, publishing and paging operations for the periods indicated and the percentage contribution of each to the Company's total revenues (dollars in thousands):
THREE MONTHS ENDED MARCH 31, ------------------------------------------------------- 2002 2001 ----------------------- ------------------------ PERCENT OF PERCENT OF AMOUNT TOTAL AMOUNT TOTAL ------- ---------- -------- ---------- BROADCASTING NET REVENUES: Local $15,034 40.0% $ 14,699 39.8% National 7,122 18.9 6,867 18.6 Network compensation 1,273 3.4 1,726 4.7 Political 760 2.0 31 0.1 Production and other 1,264 3.4 1,719 4.6 ------- -------- -------- ------- $25,453 67.7% $ 25,042 67.8% ======= ======== ======== ======= PUBLISHING NET REVENUES: Retail $ 4,873 13.0% $ 4,555 12.3% Classified 2,999 8.0 2,998 8.1 Circulation 2,012 5.3 1,875 5.1 Other 259 0.7 312 0.9 ------- -------- -------- ------- $10,143 27.0% $ 9,740 26.4% ======= ======== ======== ======= PAGING NET REVENUES: Paging lease, sales and service $ 2,009 5.3% $ 2,147 5.8% ======= ======== ======== ======= TOTAL $37,605 100.0% $ 36,929 100.0% ======= ======== ======== =======
14 THREE MONTHS ENDED MARCH 31, 2002 COMPARED TO THREE MONTHS ENDED MARCH 31, 2001 Revenues. Total revenues for the three months ended March 31, 2002 increased $676,000, or 1.8%, over the same period of the prior year, to $37.6 million from $36.9 million. This increase was primarily attributable to the broadcasting and publishing operations. Broadcasting revenues increased $410,000, or 1.6%, from the same period of the prior year, to $25.4 million from $25.0 million. This increase in broadcasting revenues reflects the cyclical increase in political revenue. In the first quarter of 2002, the Company had revenues from political advertising of $760,000 compared to $31,000 during the first quarter of 2001. Local advertising revenue increased $335,000, or 2.3%, from the same period of the prior year, to $15.0 million from $14.7 million. National advertising revenue increased $255,000, or 3.7%, from the same period of the prior year to $7.1 million from $6.9 million. These increases in advertising revenues are due in part to an improving economy. The increases in broadcasting revenue were partially offset by a decrease in network compensation and production and other revenue. Network compensation decreased $453,000, or 26.2%, from the same period of the prior year, to $1.3 million from $1.7 million. The decrease in network compensation reflected the ongoing phase out of network compensation at certain of our television stations. Production and other revenue decreased $455,000, or 26.5%, in the current quarter as compared to that of the prior year, to $1.3 million from $1.7 million. Publishing revenues increased $403,000, or 4.1%, from the same period of the prior year, to $10.1 million from $9.7 million. This increase was due primarily to an increase in revenues from retail advertising and circulation revenues. Retail advertising revenue increased $318,000, or 7.0%, in the current quarter as compared to the same quarter of the prior year, to $4.9 million from $4.6 million due to average retail price increases. Classified advertising revenue remained consistent at $3.0 million for the first quarter of 2002. Circulation revenue increased $137,000, or 7.3%, from the same period of the prior year, to $2.0 million from $1.9 million. This increase was due primarily to subscription price increases. Paging revenues decreased $137,000, or 6.4%, from the same period of the prior year, to $2.0 million from $2.1 million. The decrease was due primarily to price competition and a reduction of units in service. The Company had approximately 72,000 pagers and 88,000 pagers in service at March 31, 2002 and 2001, respectively. Operating expenses. Operating expenses for the three months ended March 31, 2002 decreased $5.2 million, or 15.1%, from the same period of the prior year, to $29.2 million from $34.4 million, due primarily to the reduction in amortization of intangibles, lower depreciation expense and decreased broadcasting expenses. Broadcasting expenses for the three months ended March 31, 2002 decreased $827,000, or 5.1%, from the same period of the prior year, to $15.5 million from $16.3 million. This decrease resulted primarily from lower employee compensation costs associated with reduced headcount and lower fringe benefit costs, promotional costs and bad debt charges. Publishing expenses for the three months ended March 31, 2002 decreased $251,000, or 3.2%, from the same period of the prior year, to $7.7 million from $7.9 million. This decrease was the result of reduced employee-related compensation costs, lower newsprint costs resulting from a decline in newsprint prices and decreased promotional spending, partially offset by increased bad debt charges. Paging expenses for the three months ended March 31, 2002 decreased $53,000, or 3.7%, from the same period of the prior year, to $1.4 million. Corporate and administrative expenses for the three months ended March 31, 2002 increased $56,000, or 5.9%, from the same period of the prior year to $1.0 million from $944,000 due to higher payroll-related costs. Depreciation of property and equipment and amortization of intangible assets was $3.7 million for the three months ended March 31, 2002, as compared to $7.9 million for the same period of the prior year, a decrease of $4.1 million, or 52.4%. Depreciation of property and equipment decreased $645,000 or 15.1% from the first quarter of the prior year. This decrease can be attributed to certain assets becoming fully depreciated in the fourth quarter of 2001. Effective January 1, 2002, the Company implemented the Statement of Financial Accounting Standards No. 141, "Business Combinations", and No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). Under these new rules, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to 15 annual impairment tests in accordance with these standards. In accordance with these standards, amortization of intangibles decreased $3.5 million or 97.0% from the first quarter of the prior year. Amortization expense of $3.5 million was recorded in the three months ended March 31, 2001 for goodwill and other intangibles that are no longer being amortized in the three months ended March 31, 2002. Miscellaneous income. Miscellaneous income for the three months ended March 31, 2002 was $38,000 compared to $71,000 for the three months ended March 31, 2001. The decrease in miscellaneous income can be attributed to a reduction in interest income associated with overnight cash investments and interest received on a state tax refund in the first quarter of 2001. Appreciation (depreciation) in value of derivatives, net. On January 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and for Hedging Activities," as amended ("SFAS 133"). In accordance with SFAS 133, the Company recorded its interest rate swap agreement at market value on January 1, 2001. Any changes in market value of the interest rate swap agreement after January 1, 2001 are recorded as income or expense in the Company's statement of operations. The Company recognized income associated with the derivative of $389,000 in the three months ended March 31, 2002 and recognized depreciation expense associated with the derivative of $785,000 for the three months ended March 31, 2001. In the prior year, depreciation was experienced primarily due to decreasing market interest rates. In the current year, market interest rates have remained low however as interest payments on the swap agreement are made the remaining estimated liability has decreased. This decrease in the estimated remaining liability generated the $389,000 of income recorded in the current year. Interest expense. Interest expense decreased $286,000, or 3.1%, to $9.0 million for the three months ended March 31, 2002 from $9.3 million for the three months ended March 31, 2001. This decrease was due to lower interest rates. Income tax benefit. Income tax benefit for the three months ended March 31, 2002 and March 31, 2001 was $46,000 and $2.5 million, respectively. The decrease in the income tax benefit was directly attributable to the decrease in net loss before tax in the current quarter as compared to the first quarter of the prior year. Extraordinary charge on extinguishment of debt, net of income tax benefit. On December 21, 2001, the Company completed its sale of $180 million aggregate principal amount of its 9 1/4% Senior Subordinated Notes due 2011 (the "9 1/4% Notes"). On this same date, the Company instructed the trustee for its 10 5/8% Senior Subordinated Notes due 2006 (the "10 5/8% Notes") to commence the redemption in full of the 10 5/8% Notes. The net proceeds from the sale of the 9 1/4% Notes was used for the redemption of the 10 5/8% Notes. The redemption was completed on January 22, 2002 and all obligations associated with the 10 5/8% Notes were extinguished on that date. The Company recorded an extraordinary charge of approximately $11.3 million ($7.3 million after income tax) in the quarter ended March 31, 2002 in connection with this early extinguishment of debt. Cumulative effect of accounting change, net of income tax benefit. On January 1, 2002, the Company adopted SFAS 142, which requires companies to stop amortizing goodwill and certain intangible assets with an indefinite useful life. Instead, SFAS 142 requires that goodwill and intangible assets deemed to have an indefinite useful life be reviewed for impairment upon adoption of SFAS 142 and annually thereafter. Under SFAS 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. As of January 1, 2002, the Company performed the first of the required impairment tests of goodwill and indefinite lived intangible assets. As a result of the required impairment test, in the quarter ended March 31, 2002, the Company recognized a non-cash impairment of goodwill and other intangible assets of $39.5 million ($30.6 million net of income taxes). Such charge is reflected as a cumulative effect of an accounting change in the accompanying condensed consolidated statement of operations. In calculating the impairment charge, the fair value of the reporting units underlying the segments were estimated using a discounted cash flow methodology. Net loss available to common stockholders. Net loss available to common stockholders of the Company for the three months ended March 31, 2002 and March 31, 2001 was $38.2 million and $5.2 million, respectively. OUTLOOK 16 With the adoption of Regulation FD by the Securities and Exchange Commission, the Company is providing this guidance to widely disseminate the Company's outlook for the full year 2002. The guidance being provided is based on the economic and market conditions as of May 14, 2002. The Company can give no assurances as to how changes in those conditions may affect the current expectations. The Company assumes no obligation to update the guidance or expectations contained in this "Outlook" section. All matters discussed in this "Outlook" section are forward-looking and, as such, persons relying on this information should refer to the "Cautionary Statements for Purposes of the `Safe Harbor' Provisions of the Private Securities Litigation Reform Act of 1995" section below. Outlook for Full Year 2002 The Company currently believes that the general economic conditions including the modest increase in advertising expenditures experienced during the first quarter of 2002 will continue to gradually improve during the remainder of 2002. Accordingly, the Company currently anticipates that broadcast local and national revenue, excluding political revenue, and publishing revenues will demonstrate in the aggregate, modest low to mid single digit percentage increases over 2001 results throughout 2002. In addition, 2002 is a political election year and the Company expects its broadcast operations to benefit from the cyclical return of political advertising. The Company notes that in both 1998 and 2000 its television stations recorded approximately $9 million of political revenue in each year. Revenue generation, especially in light of current general economic conditions, is subject to many factors beyond the control of the Company. Accordingly, the Company's ability to forecast future revenue, within the current economic environment, is limited and actual results may vary substantially from current expectations. At present, the Company anticipates that total operating expenses, excluding depreciation and amortization, for each of the Company's operating segments for the full year 2002, will be approximately equal to 2001 results. These generally favorable operating expense expectations reflect the Company's on-going expense reduction efforts at all of its operating locations. LIQUIDITY AND CAPITAL RESOURCES Benedek Acquisition On April 1, 2002, the Company entered into a Letter of Intent to acquire Stations Holding, Inc., the parent company of Benedek Broadcasting Corporation ("Benedek") in a transaction valued at approximately $500 million. The acquisition is subject to execution of a definitive agreement, which the companies expect to execute soon, as well as approval by the Federal Communications Commission (the "FCC") of the transfer of control of Benedek's television licenses. The transaction is also subject to approval of the Delaware bankruptcy court with jurisdiction over the reorganization of Stations Holding Company, Inc. Management continues to believe that the transaction will close by the fourth quarter of 2002. The Company intends to finance the acquisition by issuing a combination of debt and equity securities. The Company is considering, among other alternatives, raising the equity financing through a secondary public offering of the Company's Common Stock. Issuance of Series C Preferred Stock On April 22, 2002, the Company issued $40 million (4,000 shares) of redeemable and convertible preferred stock to a group of private investors. The preferred stock was designated as Series C Preferred Stock and has a liquidation value of $10,000 per share. The Series C Preferred Stock is convertible into the Company's Class B Common Stock at a conversion price of $14.39 per share. The Series C Preferred Stock will be redeemable at the Company's option on or after April 22, 2007 and will be subject to mandatory redemption on April 22, 2012 at liquidation value. Dividends on the Series C Preferred Stock will accrue at 8% per annum until April 22, 2009 after which the dividend rate shall be 8.5% per annum. Dividends, when declared by the Company's board of directors may be paid at the Company's option in cash or additional shares of Series C Preferred Stock. As part of the transaction, holders of the Company's Series A and Series B Preferred Stock have exchanged all of the outstanding shares of each respective series, an aggregate fair value of approximately $8.6 million, for an equal 17 number of shares of the Series C Preferred Stock. The excess of the $8.6 million price to redeem the Series A and Series B Preferred Stock over its carrying value of $4.6 million was charged to retained earnings upon redemption in April 2002. Upon closing this transaction, the Series C Preferred Stock is the only currently outstanding preferred stock of the Company. Net cash proceeds approximated $30.5 million, after transaction fees and expenses and excluding the value of the Series A and Series B Preferred Stock exchanged into the Series C Preferred Stock. The Company used the net cash proceeds to repay all current outstanding borrowings of $13.5 million under the Company's revolving credit facility and intends to use the remaining net cash proceeds for other general corporate purposes. Digital Television Conversion The Company is currently broadcasting a digital signal at four of its thirteen stations: WRDW in Augusta, Georgia; KWTX in Waco, Texas; WEAU in Eau Claire, Wisconsin and KXII in Sherman, Texas. The Company has commenced installation of similar systems at several of its other television stations. The Company currently intends to have all such required installations completed as soon as practicable. Currently the FCC requires that all stations be operational by May of 2002. As necessary, the Company has requested and received approval from the FCC to extend the May 2002 deadline by six months for all of the Company's remaining stations that are not currently broadcasting in digital. Given the Company's good faith efforts to comply with the existing deadline and the facts specific to each extension request, the Company believes the FCC will grant any further deadline extension requests that become necessary. The estimated total multi-year (1999 through 2003) capital expenditures required to implement initial digital television broadcast systems will approximate $31.4 million which includes a capital lease with an initial capitalization cost of approximately $2.5 million for tower facilities at WVLT-TV, the Company's station in Knoxville, Tennessee. As of March 31, 2002, the Company has incurred $11.1 million of such costs. The remaining $20.3 million of expenditures is expected to be incurred at various times throughout the remainder of 2002 as the Company completes construction of its digital television broadcast systems. The remaining cash payments relating to such expenditures are expected to occur at various dates throughout 2002 and 2003. Income Taxes The Internal Revenue Service (the "IRS") is auditing the Company's federal tax return for the year ended December 31, 1996. In conjunction with this examination, the Company extended the time period that the IRS has to audit the Company's federal tax returns for the 1996 and 1997 tax years until December 31, 2001. In October 2001, the Company received a notice of deficiency from the IRS associated with its audit of the Company's 1996 federal income tax return. The IRS alleges in the notice that the Company owes approximately $12.1 million of tax plus interest and penalties stemming from certain acquisition related transactions, which occurred in 1996. Additionally, if the IRS were successful in its claims, the Company would be required to account for these acquisition transactions as stock purchases instead of asset purchases which would significantly lower the tax basis in the assets acquired. The Company believes the IRS claims are without merit and on January 18, 2002 filed a petition to contest the matter in United States Tax Court. The Company cannot predict when the tax court will conclude its ruling on this matter. 18 General The Company's working capital was $7.0 million and $18.3 million at March 31, 2002 and December 31, 2001, respectively. The decrease in working capital was due primarily to the redemption of the Company's 10 5/8% Notes and a decrease in accounts receivable due to the collection of seasonally elevated fourth quarter revenues. The Company's operations provided $265,536 and $6.4 million of cash for the three months ended March 31, 2002 and 2001, respectively. The Company's investing activities provided $163.3 million for the three months ended March 31, 2002 and used $645,866 of cash for the three months ended March 31, 2001. The difference for operating activities and investing activities between the current quarter and that of the prior year is due primarily to the early retirement of the Company's 10 5/8% Notes. The Company's financing activities used $160.9 million and $6.8 million of cash for the three months ended March 31, 2002 and 2001, respectively. The increase in cash used in financing activities resulted primarily from the redemption of the Company's 10?% Notes, which was effective January 22, 2002. The Company regularly enters into program contracts for the right to broadcast television programs produced by others and program commitments for the right to broadcast programs in the future. Such programming commitments are generally made to replace expiring or canceled program rights. Payments under such contracts are made in cash or the concession of advertising spots for the program provider to resell, or a combination of both. During the three months ended March 31, 2002, the Company paid $1.3 million for such program broadcast rights. The Company and its subsidiaries file a consolidated federal income tax return and such state or local tax returns as are required. As of March 31, 2002, the Company anticipates, for federal and certain state income taxes, that it will generate taxable operating losses for the foreseeable future. At March 31, 2002, the balance outstanding and the balance available under the Company's bank loan agreement were $212.5 million and $37.5 million, respectively, and the interest rate on the balance outstanding was 5.3%. At March 31, 2001, the balance outstanding and the balance available under the Company's bank loan agreement were $207.5 million and $63.5 million, respectively, and the effective interest rate on the balance outstanding was 8.0%. Management believes that current cash balances, cash flows from operations and available funds under its bank loan agreement will be adequate to provide for the Company's capital expenditures, debt service, cash dividends and working capital requirements. Management does not believe that inflation in past years has had a significant impact on the Company's results of operations nor is inflation expected to have a significant effect upon the Company's business in the near future. CAUTIONARY STATEMENTS FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT This quarterly report on Form 10-Q contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. When used in this report, the words "believes," "expects," "anticipates," "estimates" and similar words and expressions are generally intended to identify forward-looking statements. Statements that describe the Company's future strategic plans, goals or objectives are also forward-looking statements. Readers of this report are cautioned that any forward-looking statements, including those regarding the intent, belief or current expectations of the Company or management, are not guarantees of future performance, results or events and involve risks and uncertainties, and that actual results and events may differ materially from those in the forward-looking statements as a result of various factors including, but not limited to, (i) general economic conditions in the markets in which the Company operates, (ii) competitive pressures in the markets in which the Company operates, (iii) the effect of future legislation or regulatory changes on the Company's operations, (iv) high debt levels and (v) other factors described from time to time in the Company's filings with the Securities and Exchange Commission. The forward-looking statements included in this report are made only as of the date hereof. The Company undertakes no obligation to update such forward-looking statements to reflect subsequent events or circumstances. 19 PART II. OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 3.1 Articles of Amendment to the Articles of Incorporation of Gray Communications Systems, Inc. As executed on April 15, 2002. (b) Reports on Form 8-K On January 8, 2002, the Company filed a current report on Form 8-K where it reported that on January 2, 2002 the Company dismissed Ernst & Young LLP as the Company's principal independent accountants and that on January 7, 2002, the Company retained PricewaterhouseCoopers LLP as its principal independent accountants. 20 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. GRAY COMMUNICATIONS SYSTEMS, INC. (Registrant) Date: May 15, 2002 By: /s/ James C. Ryan ----------------------------------- James C. Ryan, Vice President and Chief Financial Officer 21