10-Q 1 d81825e10-q.txt FORM 10-Q FOR QUARTER ENDED SEPTEMBER 30, 2000 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2000 COMMISSION FILE NUMBER 0-21894 SOURCE MEDIA, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 13-3700438 (STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NUMBER) 5400 LBJ FREEWAY, SUITE 680 DALLAS, TEXAS 75240 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (972) 701-5400 (REGISTRANT'S TELEPHONE NUMBER) INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS. YES X NO ------ ------ NUMBER OF SHARES OF COMMON STOCK OUTSTANDING AT NOVEMBER 7, 2000: 17,618,712 2 SOURCE MEDIA, INC. FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2000 PART I. FINANCIAL INFORMATION
Page Number ----------- Item 1. Consolidated Financial Statements of Source Media, Inc. Consolidated Balance Sheets of Source Media, Inc. (Unaudited) December 31, 1999 and September 30, 2000 4-5 Consolidated Statements of Operations of Source Media, Inc. (Unaudited) Three and nine months ended September 30, 1999 and 2000 6 Consolidated Statements of Cash Flows of Source Media, Inc. (Unaudited) 7 Nine months ended September 30, 1999 and 2000 Consolidated Statements of Stockholder's Equity (Capital Deficiency) 8 of Source Media, Inc. (Unaudited) September 30, 2000 Notes to Consolidated Financial Statements of Source Media, Inc. (Unaudited) 9-19 Financial Statements of SourceSuite LLC Balance Sheet of SourceSuite LLC (Unaudited) September 30, 2000 20 Statement of Operations of SourceSuite LLC (Unaudited) Three months ended September 30, 2000 and Period from Inception (March 3, 2000) to September 30, 2000 21 Statement of Cash Flows of SourceSuite LLC (Unaudited) Period from Inception (March 3, 2000) to September 30, 2000 22 Statement of Members' Equity of SourceSuite LLC (Unaudited) 23 September 30, 2000 Notes to Financial Statements of SourceSuite LLC (Unaudited) Period from Inception (March 3, 2000) to September 30, 2000 24-26 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 27-33
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Page Number ----------- Item 3. Quantitative and Qualitative Disclosures About Market Risk 34 PART II. OTHER INFORMATION Item 1. Legal Proceedings 35 Item 2. Changes in Securities and Use of Proceeds 35 Item 3. Defaults Upon Senior Securities N/A Item 4. Submission of Matters to a Vote of Security Holders N/A Item 5. Other Information N/A Item 6. Exhibits and Reports on Form 8-K 35
3 4 SOURCE MEDIA, INC. CONSOLIDATED BALANCE SHEETS ASSETS (IN THOUSANDS) (UNAUDITED)
DECEMBER 31, SEPTEMBER 30, 1999 2000 ------------- ------------- Current Assets: Cash and cash equivalents $ 10,910 $ 13,171 Short-term investments 2,500 -- Restricted investments 5,997 339 Trade accounts receivable, less allowance for doubtful accounts of $605 and $558 in 1999 and 2000, respectively 1,643 1,573 Related party receivables 1,458 473 Prepaid expenses and other current assets 1,068 1,224 Investment in securities available for sale -- 25,639 ------------- ------------- Total current assets 23,576 42,419 Property and equipment: Production equipment 4,511 4,403 Computer equipment 3,612 3,461 Other equipment 1,612 2,626 Furniture and fixtures 656 659 ------------- ------------- 10,391 11,149 Accumulated depreciation 7,957 9,953 ------------- ------------- Net property and equipment 2,434 1,196 Intangible assets: Goodwill 3,688 3,688 Contract rights 11,933 11,933 ------------- ------------- 15,621 15,621 Accumulated amortization 6,119 7,871 ------------- ------------- Net intangible assets 9,502 7,750 Investment in joint venture 18,669 2,766 Other non-current assets 3,835 2,977 ------------- ------------- Total assets $ 58,016 $ 57,108 ============= =============
See accompanying Notes to Consolidated Financial Statements. 4 5 SOURCE MEDIA, INC. CONSOLIDATED BALANCE SHEETS LIABILITIES AND STOCKHOLDERS' EQUITY (CAPITAL DEFICIENCY) (IN THOUSANDS) (UNAUDITED)
DECEMBER 31, SEPTEMBER 30, 1999 2000 ------------- ------------- Current Liabilities: Trade accounts payable $ 955 $ 567 Accrued interest 1,991 4,566 Accrued payroll 591 558 Other accrued liabilities 3,706 2,791 Unearned income 1,925 1,911 ------------- ------------- Total current liabilities 9,168 10,393 Long-term debt 96,250 88,533 Minority interests in consolidated subsidiaries 3,840 3,840 Note receivable and accrued interest from minority stockholder, net of discount of $12 and $0 in 1999 and 2000, respectively (837) (860) ------------- ------------- 3,003 2,980 Senior redeemable payment-in-kind (PIK) preferred stock, $25 dollar per share liquidation preference, $.001 par value, net of discount Authorized shares - 1,712; Issued and outstanding shares 1,043 and 529 in 1999 and 2000, respectively 18,467 8,426 Non-participating preferred stock, $25 dollar per share liquidation preference, $.001 par value; Authorized and issued - 1 single share -- -- Stockholders' equity (capital deficiency): Common stock, $.001 par value: Authorized shares - 50,000; 16,278 and 17,869 issued and outstanding in 1999 and 2000, respectively 16 18 Less treasury stock, at cost - 268 and 250 shares in 1999 and 2000, respectively (2,647) (2,476) Capital in excess of par value 120,883 136,550 Accumulated other comprehensive income -- (61,799) Accumulated deficit (187,124) (125,517) ------------- ------------- Total stockholders' equity (capital deficiency) (68,872) (53,224) ------------- ------------- Total liabilities and stockholders' equity (capital deficiency) $ 58,016 $ 57,108 ============= =============
See accompanying Notes to Consolidated Financial Statements. 5 6 SOURCE MEDIA, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
THREE MONTHS THREE MONTHS NINE MONTHS NINE MONTHS ENDED ENDED ENDED ENDED SEPTEMBER 30, 1999 SEPTEMBER 30, 2000 SEPTEMBER 30, 1999 SEPTEMBER 30, 2000 ------------------ ------------------ ------------------ ------------------ Monetary revenues $ 4,275 $ 4,063 $ 13,624 $ 12,626 Nonmonetary revenues 555 397 1,437 1,723 ------------------ ------------------ ------------------ ------------------ Total revenues 4,830 4,460 15,061 14,349 Monetary cost of sales 3,085 2,422 9,826 7,479 Nonmonetary cost of sales 555 397 1,437 1,723 ------------------ ------------------ ------------------ ------------------ Total cost of sales 3,640 2,819 11,263 9,202 ------------------ ------------------ ------------------ ------------------ Gross profit 1,190 1,641 3,798 5,147 Selling, general and administrative expenses 4,122 2,634 18,223 9,053 Amortization of intangible assets 1,236 584 3,709 1,752 Research and development expenses 783 -- 2,302 -- ------------------ ------------------ ------------------ ------------------ 6,141 3,218 24,234 10,805 ------------------ ------------------ ------------------ ------------------ Operating loss (4,951) (1,577) (20,436) (5,658) Interest expense 3,208 2,843 9,621 8,926 Interest income (104) (169) (640) (632) Equity interest in losses of joint venture -- 734 -- 3,443 Gain on sale of interest in joint venture -- -- -- (74,977) Other expense (income) -- 110 (2) 214 ------------------ ------------------ ------------------ ------------------ Net income (loss) before extraordinary item (8,055) (5,095) (29,415) 57,368 Extraordinary item - gain on extinguishment of debt -- 1,709 -- 4,239 ------------------ ------------------ ------------------ ------------------ Net income (loss) (8,055) (3,386) (29,415) 61,607 Preferred stock dividends (difference on conversion of preferred stock, net of dividend) 4 (1,763) 1,433 (5,643) ------------------ ------------------ ------------------ ------------------ Net income (loss) attributable to common stockholders $ (8,059) $ (1,623) $ (30,848) $ 67,250 ================== ================== ================== ================== Other comprehensive income (loss): Unrealized loss on available for sale securities -- (332) -- (61,799) ------------------ ------------------ ------------------ ------------------ Comprehensive Income $ (8,059) $ (1,955) $ (30,848) $ 5,451 ================== ================== ================== ================== Basic and diluted net loss per common share: Basic: Net income (loss) before extraordinary item per common share $ (0.60) $ (0.19) $ (2.32) $ 3.79 Extraordinary item $ -- $ 0.10 $ -- $ 0.25 ------------------ ------------------ ------------------ ------------------ Net loss attributable to common stockholders $ (0.60) $ (0.09) $ (2.32) $ 4.04 ================== ================== ================== ================== Weighted average basic common shares outstanding: 13,499 17,451 13,285 16,648 ================== ================== ================== ================== Diluted: Net income (loss) before extraordinary item per common share $ (0.60) $ (0.19) $ (2.32) $ 3.63 Extraordinary item $ -- $ 0.10 $ -- $ 0.24 ------------------ ------------------ ------------------ ------------------ Net loss attributable to common stockholders $ (0.60) $ (0.09) $ (2.32) $ 3.87 ================== ================== ================== ================== Weighted average diluted common shares outstanding: 13,499 17,451 13,285 17,353 ================== ================== ================== ==================
See accompanying notes to Consolidated Financial Statements 6 7 SOURCE MEDIA, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
NINE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, 1999 SEPTEMBER 30, 2000 ------------------ ------------------ OPERATING ACTIVITIES Net income (loss) $ (29,415) $ 61,607 Adjustments to reconcile net income (loss) to net cash used in operating activities: Depreciation 2,032 1,337 Amortization of intangible assets 3,709 1,753 Deferred Compensation 894 1,077 Non-cash interest expense 619 857 Non-cash interest income (296) (118) Provision for losses on accounts receivable 250 (47) Gain on sale of joint venture -- (74,977) Equity investment in losses of joint venture -- 3,443 Extraordinary gain on issuance of common stock in exchange for notes (4,239) Changes in operating assets and liabilities: Trade accounts receivable 1,854 116 Related party receivable -- 985 Prepaid expenses and other current assets (436) (171) Deferred expenses (54) 15 Trade accounts payable and accrued liabilities 4,915 1,230 Accrued interest (43) (23) Unearned income 602 (14) ------------------ ------------------ Net cash used in operating activities (15,369) (7,169) INVESTING ACTIVITIES Capital expenditures (1,166) (99) Redemption of investments -- 5,775 Redemption of short-term investments 6,000 2,500 Proceeds from sale of joint venture -- 4,392 Investment in SourceSuite LLC -- (4,392) ------------------ ------------------ Net cash provided by investing activities 4,834 8,176 FINANCING ACTIVITIES Proceeds from issuance of common stock 3,315 1,009 Warrants exercised 1,164 244 Other 162 1 ------------------ ------------------ Net cash provided by financing activities 4,641 1,254 ------------------ ------------------ Net increase (decrease) in cash and cash equivalents (5,894) 2,261 Cash and cash equivalents at beginning of period 11,662 10,910 ------------------ ------------------ Cash and cash equivalents at end of period $ 5,768 $ 13,171 ================== ==================
See accompanying Notes to Consolidated Financial Statements 7 8 SOURCE MEDIA, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (CAPITAL DEFICIENCY) (IN THOUSANDS) (UNAUDITED)
COMMON STOCK CAPITAL IN --------------------------- TREASURY EXCESS OF ACCUMULATED SHARES AMOUNT STOCK PAR VALUE DEFICIT ------------ ------------ ------------ ------------ ------------ BALANCE AT DECEMBER 31, 1999 16,278 $ 16 $ (2,647) $ 120,883 $ (187,124) Issuance of common stock upon exercise of stock options 109 -- -- 837 -- Issuance of stock for employee stock plan -- -- 171 -- -- Stock compensation -- -- -- 1,077 -- Net income -- -- -- -- 61,607 Preferred stock exchange 725 1 -- 4,398 -- Warrants exercised 83 -- -- 244 -- Accumulated other comprehensive loss -- -- -- -- -- Issuance of common stock for note exchange 674 1 -- 3,468 -- Preferred stock dividends -- -- -- 5,643 -- ------------ ------------ ------------ ------------ ------------ BALANCE AT SEPTEMBER 30, 2000 17,869 $ 18 $ (2,476) $ 136,550 $ (125,517) ============ ============ ============ ============ ============ TOTAL STOCKHOLDERS' COMPREHENSIVE EQUITY (CAPITAL LOSS DEFICIENCY) ------------ ------------ BALANCE AT DECEMBER 31, 1999 $ -- $ (68,872) Issuance of common stock upon exercise of stock options -- 837 Issuance of stock for employee stock plan -- 171 Stock compensation -- 1,077 Net income -- 61,607 Preferred stock exchange -- 4,399 Warrants exercised -- 244 Accumulated other comprehensive loss (61,799) (61,799) Issuance of common stock for note exchange -- 3,469 Preferred stock dividends -- 5,643 ------------ ------------ BALANCE AT SEPTEMBER 30, 2000 $ (61,799) $ (53,224) ============ ============
See accompanying Notes to Consolidated Financial Statements 8 9 SOURCE MEDIA, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Unless the context otherwise requires, all references to the "Company" or "Source Media" include Source Media, Inc. and its wholly-owned operating subsidiaries ("Subsidiaries"), including IT Network, Inc. ("IT Network"), Interactive Channel, Inc. ("Interactive Channel"), and SMI Holdings, Inc., its other operating subsidiary, Interactive Channel Technologies Inc., ("ICTI"), as well as its wholly-owned non-operating subsidiary, Source Nevada, Inc., and SourceSuite LLC ("SourceSuite"), a 50/50 joint venture with Insight Interactive LLC ("Insight"), a subsidiary of Insight Communications Company, Inc. 1. Basis of Presentation The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and the instructions for 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, these financial statements include all adjustments, consisting of normal recurring accruals, necessary to present fairly the financial position, results of operations and cash flows of the Company and its consolidated subsidiaries for the periods indicated. Operating results for the three and nine months ended September 30, 2000 are not necessarily indicative of the results that may be expected for the year ending December 31, 2000. The balance sheet at December 31, 1999 has been derived from the audited financial statements at that date. For further information, refer to the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 1999. On March 3, 2000 Source Media and Insight sold their respective interests in a joint venture to Liberate Technologies ("Liberate") in exchange for the issuance of 886,000 shares of common stock of Liberate and $4.4 million of cash to each of Source Media and Insight. Prior to the sale of the joint venture, cash equal to the value (as determined by an independent appraisal) of certain retained businesses, consisting of the interactive programming guide and related content business, was contributed by the joint venture to SourceSuite, of which Source Media and Insight each own 50%. SourceSuite used these funds to purchase the retained businesses from the joint venture, which were comprised of fixed assets with a net book value of approximately $200,000 and certain accrued liabilities, for $1.1 million. 9 10 The following represents the unaudited pro forma results of operations of Source Media as if the joint venture with Insight and subsequent sale to Liberate had occurred on January 1, 1999.
Three Months Ended Nine Months Ended Nine Months Ended September 30, 1999 September 30, 1999 September 30, 2000 ------------------ ------------------ ------------------ Total revenues 4,830 15,020 14,349 Operating loss (2,353) (12,382) (5,658) Net income (loss) attributed to common stockholders (5,993) (24,787) 68,336 Net income (loss) per common share (0.44) (1.87) 3.85
2. Equity Investment in Joint Venture The Company recorded its share of results of operations of its original joint venture with Insight up to March 3, 2000 and records its share of operating results of SourceSuite using the equity method in the Consolidated Statement of Operations. The Company owns a 50% interest in SourceSuite, which provides SourceGuide, an interactive programming guide; LocalSource, an interactive television programming service; and is developing other applications for the interactive television industry. SourceSuite is managed by the Company within the terms of the operating agreement and the annual operating plan approved by the management committee. Special actions by SourceSuite require approval of a four-member management committee comprised of two representatives from each of Source Media and Insight. The Operating Agreement of SourceSuite restricts any distribution of equity to members for a period of three years. 3. Computation of Net Income (Loss) Per Common Share The Company computes net income (loss) per share in accordance with Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS No. 128). Basic net income (loss) per common share is computed by dividing net income (loss) attributed to common stockholders by the weighted average number of common shares outstanding. In computing dilutive net income (loss) per share, options, warrants, and convertible securities are excluded if their effect would be antidilutive. The reconciliation between the numerator of Basic and Diluted net income (loss) per common share is as follows: 10 11
Three Months Ended Nine Months Ended September 30, September 30, September 30, September 30, ------------- ------------- ------------- ------------- 1999 2000 1999 2000 ---- ---- ---- ---- Numerator for both basic and diluted net income (loss) per share: Net income (loss) before extraordinary items (8,055) (5,095) (29,415) 57,368 Extraordinary items -- 1,709 -- 4,239 Preferred dividend (4) 1,763 (1,433) 5,643 -------- -------- --------- ------- Income (loss) available to common stockholders $(8,059) $(1,623) $(30,848) $67,250 ======== ======== ========= =======
The reconciliation between the denominator of Basic and Diluted net income (loss) per common share is as follows:
Three Months Ended Nine Months Ended September 30, September 30, September 30, September 30, ------------- ------------- ------------- ------------- 1999 2000 1999 2000 ---- ---- ---- ---- Denominator for basic net income (loss) per share - weighted average shares 13,499 17,451 13,285 16,648 Effect of dilutive securities: Employee stock options -- -- -- 141 Warrants -- -- -- 564 ------------- ------------- ------------- ------------- Dilutive potential common shares -- -- -- 705 Denominator for diluted net income (loss) per share - adjusted weighted average shares and assumed conversions 13,499 17,451 13,285 17,353 ============= ============= ============= ============= Basic: Net income (loss) per share before extraordinary item $ (0.60) $ (0.19) $ (2.32) $ 3.79 Extraordinary gain -- 0.10 -- 0.25 ------------- ------------- ------------- ------------- Net income (loss) attributable to common stockholders $ (0.60) $ (0.09) $ (2.32) $ 4.04 ============= ============= ============= ============= Diluted: Net income (loss) per share before extraordinary item $ (0.60) $ (0.19) $ (2.32) $ 3.63 Extraordinary gain -- 0.10 -- 0.24 ------------- ------------- ------------- ------------- Net income (loss) attributable to common stockholders $ (0.60) $ (0.09) $ (2.32) $ 3.87 ============= ============= ============= =============
11 12 4. Available for Sale Securities Investment in securities available for sale is recorded at market value as of the reporting date. Temporary declines in market value are charged to shareholders' equity. Other than temporary declines in market value, if any, are charged to earnings. The closing price per share of the Liberate common stock at September 29, 2000 was $28.9375 resulting in an aggregate value of $25.6 million. The decline from the previous quarter has been reflected in other comprehensive income and charged to Shareholder's equity. Management does not currently believe the decline in market value of the Liberate common stock to be other than temporary. 5. New Accounting Pronouncements Financial Accounting Statement ("FAS") 133, Accounting for Derivative Instruments and Hedging Activities was issued in June 1998, and amended by FAS 137 and FAS 138 to be effective for all fiscal quarters of fiscal years beginning after June 15, 2000. The Company has not yet adopted or completed its assessment of the implications of this statement. The Company is also considering the effects of the SEC Staff Accounting Bulletin No. 101, Revenue Recognition ("SAB 101") that is to be effective no later than the fourth fiscal quarter of fiscal years beginning after December 15, 1999. If the Company were to change its current revenue recognition methodology in accordance with SAB 101, the Company would expect this change in accounting policy to have a negative impact on fourth quarter revenues, but to have a positive revenue effect for the full year 2000. Net income for the year would decrease due to the impact of the cumulative effect of the accounting change. Additionally, the Company has completed its evaluation of the effects of FASB Interpretation 44, Accounting for Certain Transactions Involving Stock Options ("FIN 44") and believes that the Company is in compliance with FIN 44. 6. Commitments and Contingencies On August 21, 1998, the first of fourteen class action complaints were filed against the Company and certain of its present and former officers and directors in the United States District Court for the Northern District of Texas asserting violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10-b5 promulgated thereunder. The fourteen complaints were consolidated into the first filed case. Plaintiffs filed an amended complaint on March 3, 1999. The plaintiffs sought damages in an unspecified amount. On May 1, 2000, the Court set a series of deadlines for the disposition of the case with the trial set for April 16, 2001. The Company believes this case is totally without merit and intends to vigorously defend itself and its officers and directors. In addition, the Company is aware of certain claims against the Company that have not developed into litigation, or if they have, are dormant, and in any case, if determined adversely to the Company, are not expected to have a material adverse affect on the Company. Further, the Company is involved in routine litigation in the ordinary course of business, none of which, either singly or in the aggregate, if determined adversely to the Company, is expected to have a material adverse effect on the Company's results of operations or its financial condition. 12 13 The Company has employment agreements with five senior executives which expire in 2001 and 2002. The agreements generally provide that the Company will pay a base salary amount and grant stock options to the employees, which vest over a fixed period, typically four years. In the event of a termination without cause, the Company remains obligated to make certain payments as defined in the agreements. 7. Long-Term Debt On October 30, 1997, the Company issued Senior Secured Notes (the "Notes"), in the principal amount of $100 million, which bear interest at the rate of 12% per annum through November 1, 2004. Interest on the Notes is payable semi-annually on May 1 and November 1 of each year commencing on May 1, 1998, to holders of record at the close of business on April 15th or October 15th immediately preceding the interest payment date. The Company placed into an escrow account approximately $22.6 million of the net proceeds from the offering of the Notes, representing funds sufficient, together with interest thereon, to pay the first four interest payments on the Notes. Additionally, $6.0 million from the proceeds received in a transaction with Insight was placed into escrow and used to pay the May 2000 interest payment. The November 2000 interest payment was made from available cash funds. The Notes are fully and unconditionally guaranteed, jointly and severally, by all of the Company's Subsidiaries (the "Subsidiary Guarantors"). The guarantees are senior obligations of the Subsidiary Guarantors and are secured by substantially all of the assets of the Subsidiary Guarantors. The guarantees rank pari passu in right of payment with all existing and future senior indebtedness of the Subsidiary Guarantors and rank senior in right of payment to all existing and future subordinated obligations of the Subsidiary Guarantors. The guarantees may be released upon the occurrence of certain events. The guarantee executed by IT Network contains a covenant that restricts payments of dividends on its capital stock to an amount sufficient to cover debt service on the Notes, redemptions or repurchases of the Notes or the Company's Senior PIK Preferred Stock (the "Preferred Stock"), dividends on the Preferred Stock and corporate overhead. The assets of Source Media consist solely of the capital stock of its subsidiaries, investments in Liberate and SourceSuite, and the remaining invested proceeds from the issuance of the Notes and the Preferred Stock and related warrants and Insight Communication Company Inc.'s equity investment. Financial statements for the Subsidiary Guarantors and Source Media, Inc., on an unconsolidated basis, are not presented because management has determined that they would not be material to investors. In conjunction with the formation of SourceSuite, the Company pledged its membership units in SourceSuite as collateral to secure payments on the Notes. On December 13, 1999, $3.8 million of Notes were tendered to the Company and additional cash received in exchange for an exercise of warrants to purchase shares of common stock. In June and August of 2000, the Company issued 394,285 and 279,720 shares of common stock with a market value of $5.25 and $5.00 per share, respectively, in exchange for Notes with a carrying value of $4.6 million and $3.1 million, respectively. These transactions resulted in extraordinary gains of $2.5 million and $1.7 million in the quarters ended June 30 and September 30, 2000, respectively. The face value of the remaining Notes was $88.5 million at September 30, 2000. 13 14 Except as described below, the Company may not redeem the Notes prior to November 1, 2001. On or after such date, the Company may redeem the Notes, in whole or in part, at any time, at various redemption prices set forth in the indenture governing the terms of the Notes, together with accrued and unpaid interest, if any, to the date of redemption. The Notes are not subject to any sinking fund requirement. Upon the occurrence of a change in control, the Company will be required to make an offer to repurchase the Notes at a price equal to 101% of the principal amount thereof, together with accrued and unpaid interest, if any, to the date of the repurchase. The indenture contains certain covenants including, but not limited to, limitations on indebtedness, restricted payments, liens, restrictions on distributions from restricted subsidiaries, sales of assets and subsidiary stock, affiliate transactions, issuances of capital stock of restricted subsidiaries and sale/leaseback transactions. As of September 30, 2000, $88.5 million of Notes were outstanding and the dealer quoted value of a Note was $0.37 per dollar face value resulting in an aggregate fair market value of the outstanding Notes of approximately $32.7 million. 8. Senior PIK Preferred Stock On October 30, 1997, the Company issued 800 units (the "Units") for an aggregate purchase price of $20 million, each Unit consisting of 1,000 shares of non-voting Preferred Stock with a liquidation preference of $25.00 per share and 558.75 warrants (the "October 1997 Warrants"). Each October 1997 Warrant entitles the holder to purchase one share of the Company's common stock at a purchase price of $0.01 per share. In the aggregate, the October 1997 Warrants represent the right to purchase 447,000 shares of common stock. The Units were sold in connection with the Company's acquisitions of certain assets. Dividends on the Preferred Stock are payable quarterly on each February 1, May 1, August 1 and November 1, commencing February 1, 1998, at an annual rate of 13 1/2% of the liquidation preference per share. At the Company's option, any dividend payment occurring on or prior to November 1, 2002, may be paid either in cash or by the issuance of additional shares of Preferred Stock with a liquidation preference equal to the amount of such dividends; thereafter, dividends will be paid in cash. The certificate of designation governing the Preferred Stock limits the amount of cash dividends that may be paid on the Preferred Stock. Prior to November 1, 2002, the Preferred Stock is not redeemable. On or after November 1, 2002, the Company may redeem the Preferred Stock, in whole or in part, at any time, at various redemption prices, plus accumulated and unpaid dividends, to the date of redemption. Upon the occurrence of a change in control, the Company will be required to make an offer to purchase the outstanding shares of the Preferred Stock at a price equal to 101% of the liquidation preference thereof, plus accumulated and unpaid dividends, to the date of purchase. The Preferred Stock will be subject to mandatory redemption in whole on November 1, 2007, at a price equal to 100% of the then effective liquidation preference thereof, plus, without duplication, all accrued and unpaid dividends to the date of redemption. The certificate of designation contains certain covenants including, but not limited to, limitations on indebtedness, restricted payments, affiliate transactions, issuances of capital stock of restricted subsidiaries and sale/leaseback transactions. 14 15 The Preferred Stock ranks senior to all classes of common stock and to each other class of capital stock or series of Preferred Stock with respect to dividend rights and rights on liquidation, winding-up and dissolution of the Company. The Preferred Stock is non-voting except in certain circumstances. The Company may not authorize any new class of Preferred Stock that ranks senior or pari passu to the Preferred Stock without the approval of the holders of at least a majority of the shares of Preferred Stock then outstanding, voting or consenting, as the case may be, as one class, provided, however, that the Company can issue additional shares of Preferred Stock to satisfy dividend payments on outstanding shares of Preferred Stock; and further provided that the Company can issue shares of Preferred Stock ranking pari passu with the Preferred Stock if after giving effect thereto, the Consolidated Coverage Ratio, as defined in the certificate of designation, is greater than 1.7 to 1.0. During the second and third quarters, the Company entered into a number of agreements whereby it exchanged shares of its common stock for shares of Preferred Stock. In each instance, the exchange ratio was 1.2 common shares for each share of Preferred Stock. The Company issued 537,744 and 187,320 shares of common stock with a market value of $3.5 million and $0.9 million, respectively, in exchange for Preferred Stock with a carrying value of $8.2 million and $3.0 million, respectively. Dividends on preferred shares were deducted from the difference between the carrying value of preferred shares ($4.7 and $2.1 million for the quarters ended June 30 and September 30, respectively) and the market value of the common shares issued to determine the amount to be added back in arriving at net earnings (loss) available to common shareholders. At the time of issuance the estimated fair market value of the October 1997 Warrants, which was estimated to be approximately $5.5 million was credited to capital in excess of par value and the Preferred Stock was recorded at a corresponding discount. Additionally, $1.2 million of issuance costs were recorded on the Preferred Stock. The discount and issuance costs on the Preferred Stock are being accreted as additional Preferred Stock dividends using the effective dividend rate method over a ten-year period, resulting in an effective dividend rate of 19.9%. As of September 30, 2000 the dealer-quoted fair market value of the Preferred Stock was approximately $6.72 per share for an aggregate value of the outstanding Preferred Stock of $3.6 million. On February 1, May 1, and August 1, 2000, the quarterly dividends due on the Preferred Stock were paid through the issuance of additional Preferred Stock having a liquidation preference of $0.9 million, $0.9 million, and $0.5 million, respectively, with terms identical to those of the Preferred Stock. The estimated fair market value of the stock issued in lieu of a cash payment on February 1, May 1, and August 1, 2000 was approximately $0.4 million, $0.3 million, and $0.1 million, respectively, which were recorded as Preferred Stock dividends. 9. Stock Based Compensation On January 2, 1998, the Company issued stock option grants to its employees which fully vest on January 2, 2004. If certain target stock prices are met, the vesting accelerates. As a portion of the underlying shares for these options had not been authorized by the common 15 16 stockholders at the date of grant, the portion of unauthorized options were treated as a variable compensation plan through July 28, 1998, when the stockholders authorized the shares. Separately, in the second quarter of 2000, the Company accelerated the vesting and modified the terms of stock options associated with the severance of an employee which resulted in $0.6 million of compensation expense on the new measurement date. The Company has recognized stock compensation income of $0.3 million and expense of $0.2 million in selling, general and administrative expense for the three months ended September 30, 1999 and 2000, respectively. Total expense amounted to $0.9 million and $1.1 million, respectively, for the nine month periods ended September 30, 1999 and 2000. 10. Equity in SourceSuite Joint Venture On November 17, 1999 the Company completed the creation of a joint venture with Insight to conduct the business of its former VirtualModem(TM) and Interactive TV lines of business. The investment in the joint venture was accounted for by the equity method. The Company contributed certain assets of the "VirtualModem(TM)" and "Interactive Channel" products and businesses in exchange for a 50% ownership in the joint venture. Insight contributed $13 million in cash to the joint venture in exchange for a 50% interest. On March 3, 2000, the joint venture conveyed its Interactive TV line of business to SourceSuite and Source Media and Insight each transferred their interests in the joint venture to Liberate in exchange for the issuance to each of Source Media and Insight of 886,000 shares of Liberate common stock and $4.4 million of cash. This transaction resulted in a gain for the Company of $75.0 million in the first quarter. The gain was calculated based on the closing price of Liberate common stock on March 3, 2000 (the closing date) of $98.6875 per share, net of the Company's book basis of $17.4 million. The Company has net operating loss carry forwards in excess of the tax effect of this gain and, consequently, has reported no current or deferred income tax expense. Assets contributed to SourceSuite have been valued based on an independent appraisal of fair value and allocated to assets, liabilities and goodwill. The Company records amortization of the assets contributed to the joint venture on its historical basis. 16 17 Summary financial data of SourceSuite at September 30, 2000 is as follows (in thousands): ASSETS: Current Assets .................................... $ 5,713 Property and equipment, net ....................... 209 Intangible assets, net ............................ 752 ------- $ 6,674 ======= LIABILITIES AND MEMBERS' EQUITY: Current liabilities ............................... $ 1,058 Members' equity ................................... 5,616 ------- $ 6,674 ======= NET LOSS: Net loss from period of inception (March 3, 2000) through September 30, 2000 ....................... $(4,351) =======
11. Segment Reporting In accordance with SFAS 131, the Company has identified two reportable operating segments, IT Network and Interactive TV, for disclosure purposes. These two segments are regularly reviewed by the Company's management for determination of the allocation of resources to these businesses. IT Network sells advertising and related support services to clients who sponsor a promotional message with interactive content supplied primarily by IT Network. The Interactive TV business has developed proprietary software and interactive programming services that can enable digital, two-way television systems equipped with digital (or advanced analog) set-top boxes to deliver two-way, interactive programming with the touch of a set-top remote or the use of a wireless keyboard. The Interactive TV business includes the results of the Interactive Channel and ICTI subsidiaries and the Company's 50% equity interest in the results of SourceSuite (and its predecessor joint venture with Insight) from November 17, 1999. The total revenues, expenses and assets by reportable operating segments are used in the Company's operations and do not include general corporate overhead and assets not allocated to the operating units. These assets and expenses have been separately disclosed for reconciliation purposes. 17 18
Three Months Ended Nine Months Ended September 30, September 30, 1999 2000 1999 2000 ---------- ---------- ---------- ---------- (In Thousands) (In Thousands) Monetary revenues: IT Network $ 4,275 $ 4,063 $ 13,582 $ 12,626 Interactive TV -- -- 42 -- ---------- ---------- ---------- ---------- Total monetary revenues $ 4,275 $ 4,063 $ 13,624 $ 12,626 ========== ========== ========== ========== Nonmonetary revenues: IT Network $ 555 $ 397 $ 1,437 $ 1,723 Interactive TV -- -- -- -- ---------- ---------- ---------- ---------- Total nonmonetary revenues $ 555 $ 397 $ 1,437 $ 1,723 ========== ========== ========== ========== Net revenues: IT Network $ 4,830 $ 4,460 $ 15,019 $ 14,349 Interactive TV -- -- 42 -- ---------- ---------- ---------- ---------- Total net revenues $ 4,830 $ 4,460 $ 15,061 $ 14,349 ========== ========== ========== ========== Operating loss: IT Network $ (1,617) $ (958) $ (5,372) $ (3,031) Interactive TV (2,598) -- (8,053) -- Corporate (736) (619) (7,011) (2,627) ---------- ---------- ---------- ---------- Total operating loss $ (4,951) (1,577) $ (20,436) $ (5,658) ========== ========== ========== ========== Equity interest in loss of joint venture: Interactive TV $ -- $ (734) $ -- $ (3,443) ========== ========== ========== ==========
December 31, 1999 September 30, 2000 ----------------- ------------------ Identifiable assets: IT Network $15,474 $12,626 Interactive TV 20,675 -- Corporate 21,867 44,482 ------- ------- Total identifiable assets $58,016 $57,108 ======= ======= Investment in joint venture: Interactive TV $18,669 $ 2,766 ======= =======
12. Restatement of June 30, 2000 Financial Statements The Company has restated its financial statements for the quarter and six months ended June 30, 2000 to reflect a previously reported gain on the extinguishments of debt as an extraordinary item rather than as a change in equity, and to reflect the benefit realized upon the exchange of common shares for shares of Preferred Stock as an increase (decrease) in income (loss) attributable to common shares. These changes increased net income for the quarter and six months ended June 30, 2000 by $7.2 million and increased basic income per share for the quarter and six months by $0.44 and diluted net income per share by $0.44 and $0.42 per share for the quarter and six months, respectively. The restatement had no effect on the Company's cash flows or financial position. 18 19 13. Subsequent Events On November 8, 2000, the Company approved the extension of the exercise period of Warrants to purchase the Company's Common Stock. The expiration date of the "Public Warrants," originally issued June 23, 1993 and previously scheduled to expire December 22, 2000, was extended to December 21, 2001. 19 20 SOURCESUITE LLC BALANCE SHEET SEPTEMBER 30, 2000 (DOLLARS IN THOUSANDS) (UNAUDITED) ASSETS Current Assets: Cash and cash equivalents $ 4,871 Related Party Receivable 488 Prepaid expenses and other current assets 354 ---------- Total current assets 5,713 Property and equipment: Computer and production equipment 249 Accumulated depreciation 40 ---------- Net property and equipment 209 Intangible assets: Goodwill 858 Accumulated amortization 106 ---------- Net intangible assets 752 ---------- Total assets $ 6,674 ========== LIABILITIES AND MEMBERS' EQUITY Current Liabilities: Accounts payable $ 18 Accrued liabilities 567 Payable to Source Media, Inc. 473 ---------- Total current liabilities 1,058 Members' equity, 1,000,000 units authorized and outstanding 9,967 Accumulated deficit (4,351) ---------- Total Members' Equity 5,616 ---------- Total liabilities and members' equity $ 6,674 ==========
See accompanying Notes to Consolidated Financial Statements. 20 21 SOURCESUITE LLC STATEMENT OF OPERATIONS (DOLLARS IN THOUSANDS) (UNAUDITED)
THREE MONTHS PERIOD OF INCEPTION ENDED (MARCH 3, 2000) TO SEPTEMBER 30, 2000 SEPTEMBER 30, 2000 ------------------ ------------------ Revenues $ 24 $ 24 Operating expenses: Selling, general and administrative expenses 1,553 4,514 Amortization of intangible assets 43 106 ------------------ ------------------ Total operating expenses 1,596 4,620 ------------------ ------------------ Operating loss (1,572) (4,596) Interest income 104 245 ------------------ ------------------ Net loss $ (1,468) $ (4,351) ================== ==================
See accompanying Notes to Consolidated Financial Statements. 21 22 SOURCESUITE LLC STATEMENT OF CASH FLOWS PERIOD OF INCEPTION (MARCH 3, 2000) TO SEPTEMBER 30, 2000 (DOLLARS IN THOUSANDS) (UNAUDITED) OPERATING ACTIVITIES Net Loss $(4,351) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation 27 Amortization of intangible assets 106 Changes in operating assets and liabilities: Related party receivable 599 Prepaid expenses and other current assets (312) Trade accounts payable and accrued liabilities 84 Related party payable (66) ------- Net cash used in operating activities (3,913) INVESTING ACTIVITIES Capital expenditures (48) ------- Net cash used in investing activities (48) ------- Net decrease in cash and cash equivalents (3,961) Cash and cash equivalents at beginning of period 8,832 ------- Cash and cash equivalents at end of period $ 4,871 ======= See accompanying Notes to Consolidated Financial Statements. 22 23 SOURCESUITE LLC STATEMENT OF MEMBERS' EQUITY SEPTEMBER 30, 2000 (DOLLARS IN THOUSANDS) (UNAUDITED)
MEMBERSHIP MEMBERS' UNITS EQUITY ------------- ------------- Sale of membership units on March 3, 2000 1,000,000 $ 9,967 Net loss -- (4,351) ------------- ------------- September 30, 2000 1,000,000 $ 5,616 ============= =============
See accompanying Notes to Consolidated Financial Statements. 23 24 SOURCESUITE LLC NOTES TO FINANCIAL STATEMENTS PERIOD FROM INCEPTION (MARCH 3, 2000) THROUGH SEPTEMBER 30, 2000 1. DESCRIPTION OF BUSINESS SourceSuite LLC ("SourceSuite" or "Company"), a Delaware limited liability company, was formed on March 3, 2000 as a 50/50 joint venture between Source Media, Inc. ("Source Media") and Insight Interactive, LLC ("Insight"). On November 17, 1999 Source Media conveyed certain assets related to its VirtualModem(TM)" and "Interactive Channel" products and businesses and Insight contributed $13 million in cash to a joint venture in exchange for each owning a 50% interest in that joint venture. On March 3, 2000, Source Media and Insight sold their respective interests in the joint venture to Liberate Technologies ("Liberate") in exchange for the issuance of 886,000 shares of common stock of Liberate to each of Source Media and Insight and $4.4 million of cash. Prior to the sale of the joint venture, cash equal to the value (as determined by an independent appraisal) of certain retained businesses, consisting of SourceGuide, an interactive programming guide; LocalSource, an interactive television programming service; and related content, was contributed by the joint venture to SourceSuite. SourceSuite used these funds to purchase the retained business from the joint venture, which comprised of fixed assets with a net book value of approximately $200,000 and certain accrued liabilities, for $1.1 million. SourceSuite will continue the development of the proprietary software contributed by Source Media and will provide interactive programming services that are enabled on digital, two-way television systems equipped with digital (or advanced analog) set-top boxes to deliver two-way, interactive programming with the touch of a set-top remote or the use of a wireless keyboard. Liberate provides SourceSuite, without charge, specific software development services for the Interactive TV products under a programming services agreement. SourceSuite entered into a preferred content provider agreement with Liberate pursuant to which Liberate offers pricing incentives to its customers that use SourceSuite's local content services with the VirtualModem(TM) products. 2. ACCOUNTING POLICIES Basis of Presentation Assets contributed to the joint venture by Source Media have been valued at the fair value on the date of contribution based on an independent appraisal and allocated to assets, liabilities and goodwill. 24 25 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 amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Cash and Cash Equivalents The Company classifies all highly liquid investments with original maturities of three months or less as cash equivalents. These investments are recorded at cost, which approximates market. Computer and Production Equipment Computer and production equipment are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives (three to five years) of the assets. Intangible Assets Goodwill resulted from the difference between the cash received for the fair value of the assets contributed to the joint venture and their recorded values. Intangible assets are amortized using the straight-line method over an estimated useful life of five years. The carrying value of intangible assets is reviewed for impairment whenever events or changes in circumstances indicated that there may be an impairment. If the review indicates that any of the intangibles will not be recoverable, as determined by an analysis of undiscounted cash flows, the intangible asset will be reduced to its estimated fair value. Comprehensive Income There are no significant comprehensive income items, therefore, comprehensive income is equal to net income and not separately shown on the Statement of Operations. 3. INCOME TAXES SourceSuite has experienced net operating losses from inception. Accordingly, no provision for income taxes has been recorded. A valuation allowance has been established to fully offset the deferred tax asset associated with SourceSuite's net operating loss carry forwards. 4. MEMBERS' EQUITY Distribution of equity to members is restricted by the Company's Operating Agreement for a period of three years. 25 26 5. RELATED PARTY TRANSACTIONS As part of the joint venture agreement between Source Media and Insight, Source Media manages the day-to-day operations of SourceSuite within the terms of SourceSuite's operating plan. As part of this arrangement, SourceSuite reimburses Source Media for the direct costs of the Interactive TV business and certain overhead costs. These costs have been included in the payable to related parties and are reimbursed to Source Media on a regular basis. Additionally, SourceSuite purchases certain hardware on behalf of Insight. These amounts are billed to Insight and included in related party receivables. 6. COMMITMENTS AND CONTINGENCIES Upon formation, SourceSuite assumed the responsibility for the following litigation: On October 6, 1998, Advanced Interactive, Inc. filed a complaint in U.S. District Court for the Northern District of Illinois, Eastern Division, against ICTI and the following companies: Matsushita Electric Corporation, Matsushita Electric Industrial Co., Ltd., Sharp Electronics Corp., Sharp Corp., Thomson Consumer Electronics, Toshiba Consumer Products, Inc., Toshiba American, Inc., Toshiba Corporation, General Instruments Corp., Scientific Atlanta, Inc., ATI Technologies, Inc., ADS Technologies Inc., Gateway 2000, Inc., STB Systems, Inc., Hauppauge Computer Works, Inc., WebTV Networks, Inc. and WorldGate Communications, Inc. (collectively the "Defendants"). Advanced Interactive, Inc. alleges that ICTI infringed two claims of one of its patents by manufacturing, using and/or selling or offering to sell Sourceware(TM) ChannelLink(TM). The same allegation is made against each Defendant for its particular product or service. The Plaintiff seeks damages, but makes no claims against the patents of ICTI or any other Defendant. ICTI, and each of the Defendants, have filed an Answer and have collectively joined the Motion for Partial Summary Judgment submitted by Matsushita Electric Corporation of America, Sharp Electronics Corp., Sharp Corp. and the Toshiba Defendants. On June 26, 2000, the court entered a judgement that ICTI does not infringe on Advanced Interactive's patent. The Plaintiff has filed a Notice of Appeal of this judgement in the U.S. Court of Appeals of the Federal Circuit dated August 3, 2000. This case was transferred to the joint venture between Source Media and Insight in November 1999 and was assumed by SourceSuite on March 3, 2000. The Company is vigorously defending the appeal. 26 27 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Unless the context otherwise requires, all references to "we", "us" or "our" include Source Media, Inc., its wholly-owned operating subsidiaries ("Subsidiaries"), including IT Network, Inc. ("IT Network"), Interactive Channel, Inc. ("Interactive Channel"), and SMI Holdings, Inc., its other operating subsidiary, Interactive Channel Technologies Inc. ("ICTI"), as well as its wholly-owned non-operating subsidiary, Source Nevada, Inc., and SourceSuite LLC, a 50/50 joint venture with Insight Interactive LLC ("Insight"), a subsidiary of Insight Communications Company, Inc. FORWARD LOOKING INFORMATION AND RISK FACTORS We or our representatives from time to time may make, or may have made, certain forward-looking statements, whether orally or in writing, including without limitation any such statements made, or to be made, in the Management's Discussion and Analysis of Financial Condition and Results of Operations, press releases and other information contained in our various filings with the Securities and Exchange Commission. We wish to ensure that such statements are accompanied by meaningful cautionary statements, so as to ensure to the fullest extent possible the protections of the "safe harbor" established in the Private Securities Litigation Reform Act of 1995. Accordingly, such statements are qualified in their entirety by reference to, and are accompanied by, the following discussion of certain important factors that could cause actual results to differ materially from those projected in such forward-looking statements. We caution you that this list of factors does not describe all of the risks of an investment in our common stock. We operate in a rapidly changing business environment, and new risk factors continually emerge. We cannot predict every risk factor, nor can we assess the impact of all these risk factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ from those projected in any forward-looking statements. Accordingly, you should not rely upon forward-looking statements as a prediction of our actual results. Among the factors that could cause actual results to differ materially from our expectations are our high degree of leverage and our ability to service debt, the need for additional financing, that we may not have sufficient collateral to repay our indebtedness in full, the potential for a change of control that would require us to purchase our notes and Preferred Stock, historical and projected losses, access to channels on cable television systems and uncertainty of subscriber acceptance, the uncertainty of a market for interactive television, the availability of programming, the further technical development needed to improve the economics of deploying interactive television to multiple cable systems, a delay in the roll-out of digital set-top boxes, competition within the industry, rapid technological advances that could render our products obsolete or non-competitive, anti-takeover effects of our shareholder rights plan, stock volatility, the market price of our common stock, the market price of our investments, our ability to attract and retain key 27 28 management personnel, government regulation and other factors discussed from time to time in our Annual Report on Form 10-K and other Securities and Exchange Commission filings. GENERAL The following discussion should be read in conjunction with our Consolidated Financial Statements and related notes which are included elsewhere in this report. We provide streaming media content and sell interactive advertising that can be accessed over the telephone and the Internet. We also own a 50% interest in SourceSuite LLC, a joint venture we manage, which provides interactive cable television programming services, including a fully interactive program guide, known as SourceGuide(TM), and an information entertainment service, known as LocalSource(TM). We categorize these operations as our IT Network business and our Interactive TV business. We have experienced significant changes in our Interactive TV business since the second quarter of 1999. In November 1999 we contributed this business to a 50/50 joint venture with Insight. Insight contributed $13 million of equity financing to the joint venture and purchased 842,105 shares of our common stock for $12 million ($14.25 per share) and warrants to purchase 4,596,786 additional shares of our common stock at $20 per share. On March 3, 2000, we and Insight Interactive sold our interests in the joint venture to Liberate Technologies ("Liberate") in exchange for the issuance to each of us and Insight Interactive of 886,000 shares of Liberate common stock and $4.4 million of cash. Prior to the completion of the sale, the joint venture transferred to SourceSuite its assets and properties not related to the VirtualModem(TM) products and associated businesses. The interests in the new joint venture were distributed to us and Insight Interactive, so that each became a 50% owner of SourceSuite. Liberate thus acquired all patents and intellectual property related to the VirtualModem(TM) products and businesses and granted SourceSuite an exclusive license to use the patents necessary to its business. SourceSuite's business is interactive television programming and services, including SourceGuide(TM)and LocalSource(TM). THREE MONTHS ENDED SEPTEMBER 30, 2000 AND 1999 Monetary revenues decreased 5% to $4.1 million for the three months ended September 30, 2000 from $4.3 million for the same period in 1999. The decrease was primarily driven by $0.5 million of decreased advertising sales, $0.1 million of decreased advertiser services revenues and $0.3 million of decreased information services revenue from the same period in the prior year. These decreases were partially offset by $0.7 million of revenue from new products introduced in 2000, including streaming audio sales and Internet advertising. Monetary cost of sales decreased 21% to $2.4 million for the three months ended September 30, 2000 from $3.1 million for the same period in 1999, primarily due to $0.5 million of reduced product costs due to discontinued products and decreased sales, $0.2 million of payments in 1999 to customers for unfulfilled sales guarantees and $0.2 million of cost of the 28 29 Interactive TV operations transitioned to our joint venture. These decreases were partially offset by increases of $0.2 million of other operational expenses. Nonmonetary revenues and nonmonetary cost of sales decreased 28% to $0.4 million for the three months ended September 30, 2000. Nonmonetary sales accounted for 9% of revenues for the three months ended September 30, 2000 compared to 11% of revenues for the same period in 1999. Selling, general and administrative expenses decreased 37% to $2.6 million for the three months ended September 30, 2000 from $4.1 million for the same period in 1999. The decrease is primarily due to $1.3 million of cost of the Interactive TV operations transitioned to our joint venture with Insight, a decrease of $0.5 million in professional fees and legal fees, and other operational savings of $0.3 million offset by an increase in non-cash variable compensation expense of $0.6 million. Amortization of intangible assets decreased 53% to $0.6 million from $1.2 million for the three months ended September 30, 2000 primarily due to the transfer of patents to our joint venture with Insight in 1999. Research and development activities were transferred to our joint venture with Insight in November 1999, resulting in a decrease of $0.8 million in research and development expense compared to the three months ended September 30, 1999. Equity interest includes our share of the results of operations of SourceSuite for the three months ended September 30, 2000, recorded using the equity method. Interest expense decreased 11% to $2.8 million for the three months ended September 30, 2000 from $3.2 million for the same period in 1999 due to the exchange of approximately $11.5 million of Notes for common stock since December of 1999. This expense is associated with a $100 million debt financing completed by the Company in October 1997 and described in detail in the Notes to Consolidated Financial Statements. Interest income increased 63% to $0.2 million for the three months ended September 30, 2000 from $0.1 million for the same period 1999 due to the investment of larger cash balances. Extraordinary gain resulted from the gain recorded on the exchange of $3.1 million of Notes for common stock during the third quarter. Preferred Stock dividends reflect a benefit of $2.1 million realized on the issuance of common stock in exchange for Preferred Stock, due to the excess of the carrying amount of the Preferred Stock over the fair value of the Company's common stock. This benefit is partially offset by $0.4 million of preferred dividend expense for the three months ended September 30, 2000, as compared to dividend expense of $4 thousand in the same period of 1999. Excluding the benefit, the increase in dividend expense is primarily caused by a lower Preferred Stock price in 1999. The dividends relate to the $20 million Preferred Stock financing completed by the Company in October 1997 29 30 and described in detail in the Notes to Consolidated Financial Statements. Dividends are recorded at the fair market value of the shares. NINE MONTHS ENDED SEPTEMBER 30, 2000 AND 1999 Monetary revenues decreased 7% to $12.6 million for the nine months ended September 30, 2000 from $13.6 million for the same period of 1999. This decrease is primarily due to decreases of $1.4 million in advertising sales, $0.4 million in advertising services, and $0.9 million in information services offset by an increase of $1.7 million in new product revenues including streaming audio sales and Internet advertising. Monetary cost of sales decreased 24% to $7.5 million for the nine months ended September 30, 2000 from $9.8 million for the same period in 1999 as a result of 1999 costs of $1.6 million for payment of unfulfilled sales guarantees, $0.7 million of Interactive TV costs transferred to SourceSuite, and a $0.8 million reduction in page costs related to the decreased advertising sales partially offset by increased operational costs of $0.8 million. Nonmonetary revenues and nonmonetary cost of sales increased 20% to $1.7 million for the nine months ended September 30, 2000 from $1.4 million for the same period in 1999. Nonmonetary sales accounted for 12% of revenues for the nine months ended September 30, 2000 compared to 10% of revenues for the same period in 1999. Selling general and administrative expenses decreased 50% to $9.1 million for the nine months ended September 30, 2000 from $18.2 million for the same period in 1999. The decrease is primarily due to the following: (a) $4.0 million of cost of the Interactive TV operations transitioned to our joint venture with Insight; (b) decreased legal and professional fees of $3.1 million which were incurred in 1999 in connection with a proposed joint venture that were expensed after the termination of the proposed transaction; (c) a savings of $0.4 million in severance expense in 2000; and (d) $1.6 million in cost reductions and other administrative expenses. Amortization of intangible assets decreased 53% to $1.7 million from $3.7 million for the nine months ended September 30, 2000 due to the transfer of patents to our joint venture with Insight in 1999. Research and development activities were transferred to our joint venture with Insight in November 1999 resulting in a decrease of $2.3 million in research and development expense compared to the nine months ended September 30, 1999. Other income includes $75.0 million of gain recorded upon the sale of our interest in the original joint venture with Insight to Liberate in exchange for 886,000 shares of common stock in Liberate and $4.4 million cash. 30 31 Equity interest in losses of joint venture includes our share of the results of operations of SourceSuite and its predecessor joint venture for the nine months ended September 30, 2000, recorded using the equity method. The original joint venture was formed November 17, 1999. Interest expense decreased 7% to $8.9 million for the nine months ended September 30, 2000 from $9.6 million in 1999. This decrease is due to the retirement of $11.5 million of Notes for common stock since December of 1999. The interest is associated with a $100 million debt financing completed by the company in October 1997 and described in detail in the Notes to Consolidated Financial Statements. Interest income remained consistent at $0.6 million for the nine months ended September 30, 2000. Extraordinary gain resulted from the gain recorded on the exchange of $7.7 million of Notes for common stock. Preferred Stock dividends reflects a benefit of $6.8 million realized recorded on the issuance of common stock in exchange for Preferred Stock, due to the excess of the carrying amount of the Preferred Stock over the fair value of the Company's common stock. This benefit is partially offset by $1.2 million of dividend expense for the nine months ended September 30, 2000 as compared to dividend expense of $1.4 million for the nine months ended September 30, 1999. The dividend expense relates to the $20 million Preferred Stock financing completed by the Company in October 1997 and described in detail in the Notes to Consolidated Financial Statements. Dividends are recorded at the fair market value of the preferred shares issued as payment-in-kind. Excluding the benefit the decrease is related to exchanges of Preferred Stock for common stock, which took place in the second and third quarters of this year, as well as a decrease in the fair value of the Preferred Stock issued as dividends during the nine months ended September 30, 2000. LIQUIDITY AND CAPITAL RESOURCES Since inception, we have experienced substantial operating losses and net losses as a result of our efforts to develop, deploy and support our IT Network business and to develop, conduct trials and commercially launch our Interactive TV business. As of September 30, 2000, we had an accumulated deficit of $125.5 million and had used cumulative net cash in operations of $109.9 million. The difference at September 30, 2000, between the accumulated deficit and cumulative net cash used in operations since inception was attributable primarily to charges related to financing incentives and extinguishment of debt, variable compensation expense, write-downs of analog set-top boxes and intangible assets, depreciation and amortization and other non-cash expenses. We are likely to continue to incur operating losses at least into 2001. Any launch of our television products and services through SourceSuite may require an additional capital contribution which may require us to raise additional capital. On March 3, 2000, we sold our interest in the VirtualModem(TM) business owned by our joint venture with Insight to Liberate for 886,000 shares of Liberate common stock which became freely tradable by us after July 31, 2000. In addition 31 32 to the Liberate common shares, we received from Liberate $4.4 million as a working capital adjustment which we contributed to SourceSuite. It is expected that this liquidity will provide the necessary funding for expected future capital requirements at least through 2000. The Liberate shares had an aggregate value of approximately $87.4 million, based on the closing price of Liberate common stock of $98.6875 per share on March 3, 2000. Liberate common stock is traded on the Nasdaq Stock Market under the symbol "LBRT". As of November 7, 2000, the closing price per share of the Liberate common stock was $21.0625 resulting in an aggregate value of $18.7 million. Management does not believe the decline in the Liberate stock price is other than temporary as there have been no material adverse changes in Liberate's market position or balance sheet of which management is aware. The decline in the Liberate share price appears to closely follow the general decline of equities and, particularly, the equities of technology companies. Additionally, Source Media believes it has adequate cash on-hand to meet operational requirements throughout the remainder of the year and does not expect to reduce its holding of Liberate stock in 2000. Since inception, we have financed our operations primarily with $156.6 million raised from various financing activities, including the incurrence of debt and issuance of our common stock and Preferred Stock. In October 1997, we issued $100.0 million of Notes and $20.0 million of Preferred Stock. On December 19, 1999, $3.75 million of Notes were tendered to the Company and additional cash was received in exchange for an exercise of warrants to purchase shares of common stock. On June 20, 2000 an additional $4.6 million of Notes were exchanged for common stock, and on August 16 and 17, an additional $1.6 million and $1.5 million of Notes were exchanged for common stock, respectively. As of September 30, 2000, the face value of the outstanding balance was $88.5 million. The interest escrow account created pursuant to the indenture governing the Notes has been used to fund the first four interest payments on the Notes. Interest payments from the interest escrow account were made on May 1, 1998, November 1, 1998, May 1, 1999 and November 1, 1999. Additionally, $6.0 million from proceeds received in a transaction with Insight was placed into escrow and used to pay the May 2000 interest payment. On November 1, 2000, we made our interest payment of approximately $5.4 million, which was paid out of current operating balances. Our primary source of liquidity is our cash, which totaled $13.2 million at September 30, 2000 prior to the November interest payment. Additionally, we have an investment of 886,000 shares of Liberate common stock that are now freely tradeable. We currently believe our resources will be sufficient to meet our anticipated cash needs for working capital, required interest payments and other capital expenditures related to the further development of our IT Network business and capital requirements for SourceSuite through and beyond the fourth quarter of 2000. Additionally, while we do not currently anticipate any capital calls by the joint venture, we believe our resources are sufficient to meet any capital calls through 2000. Our future capital requirements will depend on many factors, including, but not limited to the following factors, some of which are outside our control: (i) the operating results of our IT Network business, including local advertisers' willingness to purchase Internet based advertising; (ii) the success and timing of the development, introduction and deployment of the Interactive TV products; (iii) the extent of market acceptance of our products; (iv) potential 32 33 acquisitions or asset purchases; (v) the deployment of digital set-top boxes incorporating technology that we are able to access; (vi) competitive factors; and (vii) changes in the regulatory environment and (viii) general economic conditions. EFFECT OF INFLATION We believe that the effect of inflation has not been material during the three month periods ended September 30, 1999 and 2000, respectively. NET OPERATING LOSS CARRYFORWARDS At December 31, 1999, we had net operating loss carryforwards of approximately $124.5 million for U.S. Federal income tax purposes, which begin to expire in 2003. The Internal Revenue Code of 1986, as amended, imposes limitations on the use of net operating loss carryforwards if certain stock ownership changes occur. An ownership change occurred in 1995 that caused utilization of $23.1 million of our net operating losses incurred prior to the ownership change to be limited to approximately $9.0 million in a given year. 33 34 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. We are exposed to changes in interest rates related primarily to our Notes and Preferred Stock. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. At September 30, 2000, we had Notes outstanding having an aggregate principal amount of $88.5 million, due November 1, 2004, which bear interest at a fixed rate of 12% and Preferred Stock outstanding having a liquidation preference of $13.2 million, due November 1, 2007, which has a fixed dividend rate of 13 1/2%. The fair value of the Notes at September 30, 2000 was approximately $32.7 million based upon dealer quoted market price. As of September 30, 2000, the dealer-quoted fair market value of the Preferred Stock was approximately $6.72 per share for an aggregate value of the outstanding Preferred Stock of $3.6 million. We invest our cash balance in money market funds and commercial paper rated A1, and P1, respectively. These securities are in U.S. dollars, with maturities of six months or less, are held to maturity and are not owned for trading purposes. Using this strategy, we have not experienced any losses due to interest rate risk, market risk or foreign exchange risk on our commercial paper investments, and we do not anticipate any such losses. On March 3, 2000, we received 886,000 shares of Liberate common stock in exchange for our interest in our joint venture with Insight. The closing price per share of the Liberate common stock on March 3, 2000 was $98.6875, giving us a total original investment in Liberate common stock of approximately $87.4 million. We face the market risk associated with price fluctuations of the Liberate common stock until such time as we sell or hedge the stock. As of September 30, 2000, the closing price per share of the Liberate common stock was $28.9375 resulting in a total investment balance of $25.6 million. As of November 7, 2000, the closing price was $21.0625, resulting in a total investment of $18.7 million. 34 35 PART II - OTHER INFORMATION Item 1 - Legal Proceedings Reference is made to our Annual Report on Form 10-K for the year ended December 31, 1999 and to the Notes to SourceSuite's and our financial statements included in this report for a discussion of certain litigation. Item 2 - Changes in Securities and Use of Proceeds We extended the exercise period of our redeemable common stock purchase warrants, issued in June 1993, to December 22, 2001 from the previously scheduled June 23, 2000 expiration. In addition, our right to call the warrants for redemption may now be exercised if the closing price of our common stock is $13.00 or more for 10 consecutive trading days. On August 9, 2000, we issued the following stock options to various employees pursuant to our 1999 Stock Option Plan:
Number of Shares Exercise Price Underlying Options Per Share ------------------ -------------- 125,000 $ 6.890 50,000 5.235 5,000 8.425 1,500 5.328 1,500 5.078
Exemption from registration under the Securities Act of 1933 is claimed for each such issuance of securities in reliance upon the exemption afforded by Section 4(2) of the Securities Act. Item 6 - Exhibits and Reports on Form 8-K (a) Exhibits 10.1 Employment Agreement dated as of September 1, 2000, between the Company and Paul Tigh 10.2 Employment Agreement dated as of September 20, 2000, between the Company and Philip Howort 10.3 Employment Agreement dated as of October 17, 2000, between the Company and Derrick Horner Exhibit 27 - Financial Data Schedule (b) Reports on Form 8-K during the three months ended September 30, 2000. None. 35 36 SIGNATURE Pursuant to the requirements 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. SOURCE MEDIA, INC. (Registrant) Date: November 14, 2000 By: /s/ PAUL TIGH ------------------------------------- Paul Tigh Chief Financial Officer and Treasurer (Principal Financial Officer and Duly Authorized Officer) 37 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.1 Employment Agreement dated as of September 1, 2000, between the Company and Paul Tigh 10.2 Employment Agreement dated as of September 20, 2000, between the Company and Philip Howort 10.3 Employment Agreement dated as of October 17, 2000, between the Company and Derrick Horner 27 Financial Data Schedule