-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, VgL0S2RflA3DYUAjBhXJm/P5/+WC8Ag5W65NcLsuiVFNtgxSULGXHEsMz7KQ6/lr ju37b2ZHjUQu75Th2uY0hQ== 0000950134-99-010111.txt : 19991117 0000950134-99-010111.hdr.sgml : 19991117 ACCESSION NUMBER: 0000950134-99-010111 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990930 FILED AS OF DATE: 19991115 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SOURCE MEDIA INC CENTRAL INDEX KEY: 0000900029 STANDARD INDUSTRIAL CLASSIFICATION: TELEGRAPH & OTHER MESSAGE COMMUNICATIONS [4822] IRS NUMBER: 133700438 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-21894 FILM NUMBER: 99753434 BUSINESS ADDRESS: STREET 1: 5400 LBJ FREEWAY STE 680 CITY: DALLAS STATE: TX ZIP: 75231 BUSINESS PHONE: 9727015400 MAIL ADDRESS: STREET 1: 5400 LBJ FREEWAY STE 680 CITY: DALLAS STATE: TX ZIP: 75231 FORMER COMPANY: FORMER CONFORMED NAME: HB COMMUNICATIONS ACQUISITION CORP DATE OF NAME CHANGE: 19950703 10-Q 1 FORM 10-Q FOR QUARTER ENDED SEPTEMBER 30, 1999 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, 1999 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 10, 1999: 13,666,292 2 SOURCE MEDIA, INC. FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 1999
PART I. FINANCIAL INFORMATION Page Number ----------- Item 1. Consolidated Financial Statements Consolidated Balance Sheets (Unaudited) DECEMBER 31, 1998 and SEPTEMBER 30, 1999 3-4 Consolidated Statements of Operations (Unaudited) Three and nine month periods ended SEPTEMBER 30, 1998 AND 1999 5 Consolidated Statements of Cash Flows (Unaudited) Nine months ended SEPTEMBER 30, 1998 AND 1999 6 Notes to Consolidated Financial Statements (Unaudited) 7-15 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 16-23 Item 3. Quantitative and Qualitative Disclosures About Market Risk 23 PART II. OTHER INFORMATION Item 1. Legal Proceedings 24-26 Item 2. Changes in Securities and Use of Proceeds N/A 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 26-28 Item 6. Exhibits and Reports on Form 8-K 28
2 3 PART I - FINANCIAL INFORMATION SOURCE MEDIA, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) (UNAUDITED)
DECEMBER 31, SEPTEMBER 30, 1998 1999 ------------ ------------- ASSETS Current assets: Cash and cash equivalents $11,662 $ 5,768 Restricted investments 11,716 6,011 Trade accounts receivable, less allowance for doubtful accounts of $387 and $742 in 1998 and 1999, respectively 3,596 1,491 Deferred expenses 447 501 Prepaid expenses and other current assets 937 996 ------- ------- Total current assets 28,358 14,767 Property and equipment: Production equipment 6,050 6,776 Computer equipment 3,273 3,467 Other equipment 1,150 1,401 Furniture and fixtures 660 656 ------- ------- 11,133 12,300 Accumulated depreciation 6,733 8,765 ------- ------- Net property and equipment 4,400 3,535 Intangible assets: Patents 14,945 14,945 Goodwill 6,698 6,698 Contract rights 11,933 11,933 ------- ------- 33,576 33,576 Accumulated amortization 14,557 18,266 ------- ------- Net intangible assets 19,019 15,310 Other non-current assets 4,812 4,571 ------- ------- Total assets $56,589 $38,183 ======= =======
3 4 SOURCE MEDIA, INC. CONSOLIDATED BALANCE SHEETS (CONTINUED) (IN THOUSANDS) (UNAUDITED)
DECEMBER 31, SEPTEMBER 30, 1998 1999 ------------ ------------- LIABILITIES AND STOCKHOLDERS' EQUITY (CAPITAL DEFICIENCY) Current liabilities: Trade accounts payable $ 2,501 $ 826 Accrued interest 2,000 5,000 Accrued payroll 540 1,101 Other accrued liabilities 1,619 4,648 Unearned income 1,750 2,352 --------- --------- Total current liabilities 8,410 13,927 Long-term debt 100,000 100,000 Minority interests in consolidated subsidiaries 3,840 3,840 Note receivable and accrued interest from minority stockholder, net of discount of $53 and $22 in 1998 and 1999, respectively (780) (823) --------- --------- 3,060 3,017 Senior redeemable payment-in-kind (PIK) preferred stock, $25 liquidation preference, $.001 par value, net of discount Authorized shares - 1,712; Issued and outstanding shares 914 and 1009 in 1998 and 1999, respectively 16,628 18,061 Stockholders' equity (capital deficiency): Common stock, $.001 par value: Authorized shares - 50,000 Issued shares - 13,021 and 13,914 in 1998 and 1999, respectively 13 14 Less treasury stock, at cost - 280 and 275 in 1998 and 1999, respectively (2,770) (2,716) Capital in excess of par value 80,269 84,238 Accumulated deficit (148,943) (178,358) Notes receivable and accrued interest from stockholders (78) 0 --------- --------- Total stockholders' equity (capital deficiency) (71,509) (96,822) --------- --------- Total liabilities and stockholders' equity (capital deficiency) $ 56,589 $ 38,183 ========= =========
See accompanying notes. 4 5 SOURCE MEDIA, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
QUARTER QUARTER NINE MONTHS NINE MONTHS ENDED ENDED ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, 1998 1999 1998 1999 -------------------------------- -------------------------------- Monetary revenues $ 6,344 $ 4,275 $ 17,335 $ 13,624 Nonmonetary revenues 377 555 1,490 1,437 -------- -------- -------- -------- Total revenues 6,721 4,830 18,825 15,061 Monetary cost of sales 3,480 3,085 8,784 9,826 Nonmonetary cost of sales 377 555 1,490 1,437 -------- -------- -------- -------- Total cost of sales 3,857 3,640 10,274 11,263 -------- -------- -------- -------- Gross profit 2,864 1,190 8,551 3,798 Selling, general and administrative expenses 6,493 4,122 17,827 18,223 Impairment of intangible assets 0 0 25,936 0 Amortization of intangible assets 1,237 1,236 5,084 3,709 Research and development expenses 917 783 2,614 2,302 -------- -------- -------- -------- 8,647 6,141 51,461 24,234 -------- -------- -------- -------- Operating loss (5,783) (4,951) (42,910) (20,436) Interest expense 3,191 3,208 9,601 9,621 Interest income (456) (104) (1,598) (640) Other (income) expense 13 0 (27) (2) Net loss ($ 8,531) ($ 8,055) ($50,886) ($29,415) ======== ======== ======== ======== Preferred stock dividends 734 4 2,314 1,433 Net loss attributable to common stockholders (9,265) (8,059) (53,200) (30,848) ======== ======== ======== ======== Basic and diluted net loss per common share ($ 0.76) ($ 0.60) ($ 4.51) ($ 2.32) ======== ======== ======== ======== Weighted average common shares outstanding 12,195 13,499 11,792 13,285 ======== ======== ======== ========
See accompanying notes. 5 6 SOURCE MEDIA, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, 1998 1999 -------- -------- OPERATING ACTIVITIES Net loss ($50,886) ($29,415) Adjustments to reconcile net loss to net cash used in operating activities: Impairment of intangible assets 25,936 -- Depreciation 1,884 2,032 Amortization of intangible assets 5,084 3,709 Stock based compensation 1,752 894 Non-cash interest expense 602 619 Non-cash interest income (818) (296) Provision for losses on accounts receivable 251 250 Other, net (46) (43) Changes in operating assets and liabilities: Trade accounts receivable (1,786) 1,854 Prepaid expenses and other assets (43) (436) Deferred expenses 484 (54) Trade accounts payable and accrued liabilities 2,534 4,915 Unearned income (788) 602 -------- -------- Net cash used in operating activities (15,840) (15,369) INVESTING ACTIVITIES Capital expenditures (1,225) (1,166) Redemption of short-term investments 17,932 6,000 -------- -------- Net cash provided by investing activities 16,707 4,834 FINANCING ACTIVITIES Proceeds from issuance of common stock upon exercise of stock options and warrants 722 4,479 Other (160) 162 -------- -------- Net cash provided by financing activities 562 4,641 Net increase (decrease) in cash and cash equivalents 1,429 (5,894) Cash and cash equivalents at beginning of period 8,431 11,662 -------- -------- Cash and cash equivalents at end of period $ 9,860 $ 5,768 ======== ========
See accompanying notes. 6 7 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 subsidiaries, IT Network, Inc. ("IT Network"), Interactive Channel, Inc. ("Interactive Channel"), SMI Holdings, Inc. ("Holdings"), and Interactive Channel Technologies Inc., marketed under the name of VirtualModem(TM) ("ICT"). 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 months and nine months ended September 30, 1999 are not necessarily indicative of the results that may be expected for the year ended December 31, 1999. The balance sheet at December 31, 1998 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, 1998. Since its inception, the Company has financed its operations primarily with $156.6 million raised from various financing activities, including the incurrence of debt and issuance of the Company's common stock and preferred stock. In October 1997, the Company issued $100.0 million of Senior Secured Notes (the "Notes") and $20.0 million of preferred stock. The interest escrow account created pursuant to the indenture has been and will be 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 and May 1, 1999. The Company's primary source of liquidity is its cash, cash equivalents and restricted investments, which totaled $11.8 million at September 30, 1999. This cash position consisted of $6.0 million held in escrow for the November 1, 1999 interest payment and $5.8 million of cash available for operations. The Company's first interest payment of $6.0 million not currently held in escrow is due May 1, 2000. The Company currently believes its resources will be sufficient to meet the Company's anticipated cash needs for working capital and other capital expenditures related to the Company's business and operations through the fourth quarter of 1999. Upon the closing of a joint venture with a subsidiary of Insight Communications Company, Inc., the cost of Interactive TV's operations will be funded by the joint venture. Additionally, the Company will receive $12.0 million cash from the sale of common stock related to the Insight transaction which is expected to adequately fund the Company's continuing operations for approximately twelve 7 8 months and the interest payment on its debt, due on May 1, 2000. If the Insight transaction is not approved the Company would be required to seek alternative financing. There can be no assurance that the Company will be able to obtain such financing. 2. Computation of Net Loss Per Common Share Net loss per common share is calculated in accordance with Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share". Dilutive earnings per share has not been presented because the options and warrants are anti-dilutive. 3. Translation of Foreign Currencies The financial positions and results of operations of ICT and related Canadian subsidiaries are measured using local currency (Canadian dollar) as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate in effect at each balance sheet date. Statement of operations accounts are translated at the average rate of exchange prevailing during the period. Translation adjustments and foreign currency gains and losses have not been significant and accordingly, have not been separately presented. 4. Commitments and Contingencies Interactive Channel Technologies Inc. and SMI Holdings, Inc. filed a patent infringement suit against Worldgate Communications, Inc. in federal district court in Delaware in May 1998. In June 1998, Worldgate filed a Counterclaim against plaintiffs and Source Media, Inc. for, among other things, unfair competition, interference with contract, and trade secret misappropriation. The Counterclaim defendants have denied the allegations in the Counterclaim and on July 27, 1998 filed a motion to dismiss certain of Worldgate's claims. The motion was denied by Order of the Court dated May 17, 1999. The Court held a status conference on May 13, 1999. The following deadlines for the disposition of the case were set by the Court: Joinder of Parties and Amendment of Pleadings December 1, 1999 Close of Fact Discovery May 12, 2000 Close of Expert Discovery July 14, 2000 Deadline for Dispositive Motions July 21, 2000 Trial November 27, 2000 Pursuant to the Scheduling Order, limited discovery commenced on August 16, 1999. Full-scale discovery commenced on October 1, 1999. Both parties have propounded discovery requests, responses to which are due on or before December 1, 1999. On July 17, 1998, IT Network, Inc. ("ITN") filed a lawsuit against a former employee of Brite Voice Systems, Inc. ("Brite"), Michael Shell ("Shell"), the two companies he founded Interactive Media Services, Inc. ("IMS") and Interactive Information Services, LLC ("IIS"), and a third company called Talking Directories, Inc. ("TDI"). The lawsuit was filed in the Western 8 9 District of Michigan and alleged two causes of action, one for the copyright infringement against all of the defendants arising out of the defendants' alleged use of ITN's 1997 BDR Audio Guide (the "Catalogue") and the thousands of narrative scripts that correspond to the subject matter categories contained in the Catalogue (the "Scripts"), and a second for breach of contract against TDI arising out of TDI's alleged wrongful termination of its information services contract with ITN. As of September 30, 1999, the litigation was settled with respect to all defendants. A total of fourteen class action complaints were filed against Source Media, Inc. ("SMI") and certain of its 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 and Rule 10b-5 of the accompanying regulations. The fourteen complaints were consolidated by Judge Buchmeyer into the first filed case, Hartsell, et al. v. Source Media, Inc., et al., Civil Action No. 398-CV-1980-R (filed August 21, 1998), on October 9, 1998. Plaintiffs filed a motion for the appointment of lead plaintiff and lead plaintiffs' counsel on October 20, 1998. Plaintiff proposed the appointment of three law firms to serve as "Co-Lead Counsel," Weiss & Yourman, Abbey, Gardy & Squitieri, and Milberg Weiss Bershad Hynes & Lerach, LLC. On November 12, 1998, defendants filed a statement of non-opposition to the plaintiffs' motion. The Court granted plaintiffs' motion on January 5, 1999. Pursuant to an Order entered by the Court on February 24, 1999, plaintiffs' time for filing the consolidated amended complaint was extended from February 24, 1999 to March 3, 1999. Plaintiffs filed their amended complaint on March 3, 1999. Defendants filed a motion to dismiss on April 19,1999, plaintiffs filed an opposition to the motion on May 24, 1999, and defendants filed a reply brief on June 12, 1999. A hearing on the motion to dismiss was held on July 15, 1999. By Order dated July 15, 1999, the Court denied defendants' motion. On July 26, 1999, defendants filed an Application For Immediate Appellate Review Under 28 U.S.C. ss. 1292(b) concerning two issues central to the Court's denial of defendants' motion to dismiss. Plaintiffs filed an opposition on or about August 13, 1999. By Order dated August 24, 1999, the Court denied defendants' motion. On August 16, 1999, plaintiffs filed a complaint against Ernst & Young LLP, Source Media, Inc.'s outside accountants, alleging violations of the federal securities laws (the "E&Y Complaint"). The facts and circumstances underlying the E&Y Complaint are similar to those underlying the amended complaint. By Order dated August 31, 1999, the Court consolidated the E&Y Complaint with the amended complaint. Ernst & Young moved to dismiss the E&Y Complaint on September 21, 1999, plaintiffs filed an opposition to the motion on October 28, 1999 and defendants' reply brief is due on November 19, 1999. The Court held a status conference on October 8, 1999. In light of the E&Y Complaint and the resurrection of the mandatory discovery stay as to Ernst & Young, the Court continued the trial date in the case until October 2, 2000. Plaintiffs and defendants have submitted alternative scheduling proposals to the Court regarding deadlines for discovery and dispositive motions. To date, the Court has not issued a revised scheduling order. 9 10 On October 27, 1999, plaintiffs filed a Summary Notice of Pendency of Class Action advising class members of the pendency of the litigation. Plaintiffs filed a proposed Order Approving Class Notices on November 5, 1999. The proposed Order has not yet been signed by the Court. On October 6, 1998, Advanced Interactive, Inc. filed a complaint in U.S. District Court for the Northern District of Illinois, Eastern Division, against ICT 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 America, 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 "Advanced Interactive Defendants"). Advanced Interactive alleges that ICT 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 Advanced Interactive Defendant for its particular product or service. The Plaintiff seeks damages, but makes no claims against the patents of ICT or any other Advanced Interactive Defendant. ICT, 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 May 12, 1999 the court denied Advanced Interactive's Motion for Summary Judgement of Infringement. The court has not yet considered the Advanced Interactive Defendant's collective Motion for Partial Summary Judgment. The Company believes this case is totally without merit and intends to vigorously defend itself. On August 3, 1999, the Company announced that it had filed an action in the District Court of Dallas County, Texas against TV Guide, Inc. for breach of a Non-Disclosure Agreement entered into in September 1998. The petition sought damages of approximately $60 million representing the decline in share value caused by improper statements made by TV Guide and an injunction precluding TV Guide from any further violations of the Non-Disclosure Agreement. The parties entered into a settlement agreement and release effective August 31, 1999 pursuant to which TV Guide affirmed and agreed to honor the terms of the Non-Disclosure Agreement. 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 are not expected to have a material adverse affect on the Company. Further, the Company is party to ordinary routine litigation, none of which is expected to have a material adverse effect on the Company's results of operations or its financial condition. As part of the Company's review of its booking performance against customer sales guarantees, the Company anticipates a shortfall on several contracts. In connection with these guarantees, the Company has recorded a $0.2 million expense in the third quarter for a total expense of $1.6 million for the nine months ended September 30, 1999. 10 11 The Company has employment agreements with two executives. The agreements provide that the Company will pay a base salary amount and grant stock options over a set term to the employees. In the event of a termination without cause, the Company remains obligated to make certain payments as defined in the agreements. One contract terminates in 2001 and the other in 2002. In the second quarter, the Company entered into severance agreements with certain executives that provide for salary continuation for up to six months and Company payment of health insurance premiums. 5. 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, representing funds sufficient, together with interest thereon, to pay the first four interest payments on the Notes. At September 30, 1999, $6.0 million remains in escrow to pay the interest due November 1, 1999. The Notes are fully and unconditionally guaranteed, jointly and severally, by each 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 investments in its subsidiaries and invested proceeds from the Notes and the Preferred Stock and related warrants. Financial statements for the Subsidiary Guarantors and the parent, Source Media, Inc., on an unconsolidated basis, are not presented because management has determined that they would not be material to investors. 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. In addition, at any time and from time to time on or prior to November 1, 2000, the Company may, subject to certain requirements, redeem up to 35% of the aggregate principal amount of the Notes with the cash proceeds of one or more equity offerings at a redemption price equal to 112% of the principal amount to be redeemed, together with accrued and unpaid interest, if any, to the date of 11 12 redemption, provided, that, at least $65.0 million of the aggregate principal amount of the Notes remain outstanding immediately after each such 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, 1999, the dealer quoted value of a Note was $0.38 per dollar resulting in an aggregate fair market value of approximately $38.0 million. 6. 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, on any dividend payment date occurring on or prior to November 1, 2002, dividends 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 terms of the Preferred Stock limits the amount of cash dividends that may be paid on the Preferred Stock. At any time and from time to time on or prior to November 1, 2000, the Company may, subject to certain requirements, redeem up to 35% of the aggregate liquidation value of the Preferred Stock with the cash proceeds of one or more equity offerings at a redemption price equal to 113 1/2% of the liquidation preference thereof, plus accumulated dividends, on the date of redemption. After November 1, 2000 and 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. 12 13 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. 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, 1999 the dealer quoted fair market value of the preferred stock was $5.00 per share for an aggregate value of $5.0 million. On February 1, May 1 and August 1, 1999 the quarterly dividends due on the Preferred Stock were paid through the issuance of additional Preferred Stock having a liquidation preference of $0.8 million for each dividend payment, 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, 1999 was approximately $0.5 million, $0.6 million and $0.1 million, respectively, which was recorded as preferred stock dividends. 7. Stock Based Compensation The Company has granted stock options to employees in excess of shares reserved for issuance under the stock option plan at the date of grant. The portion of unauthorized options are treated as a variable compensation plan through the date an amendment to the stock option plan increasing the number of shares is approved by shareholders. The Company recognizes stock compensation expense over the vesting period of the related options. Total non-cash stock based compensation expense for the three month period ended September 30, 1998 was $1.1 million, with income of $0.3 million for the three month period ended September 30, 1999 due to a decline in the stock price. Total expense amounted to $1.8 million and $0.9 million, respectively for the nine month periods ended September 30, 1998 and 1999. 8. Segment Reporting The Company adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131") in the year ended December 31, 1998. 13 14 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. Interactive TV has designed and is developing 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 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.
Three Months Ended September 30, Nine Months Ended September 30, 1998 1999 1998 1999 --------- ---------- --------- --------- (In Thousands) (In Thousands) Monetary revenues: IT Network $ 6,243 $ 4,275 $ 17,148 $ 13,582 Interactive TV 100 - 187 42 --------- ---------- --------- --------- Total monetary revenues $ 6,343 $ 4,275 $ 17,335 $ 13,624 ========= ========== ========= ========= Nonmonetary revenues: IT Network $ 377 $ 555 $ 1,490 $ 1,437 Interactive TV - - - - --------- ---------- --------- --------- Total nonmonetary revenues $ 377 $ 555 $ 1,490 $ 1,437 ========= ========== ========= ========= Net revenues: IT Network $ 6,620 $ 4,830 $ 18,638 $ 15,019 Interactive TV 100 - 187 42 --------- ---------- --------- --------- Total net revenues $ 6,720 $ 4,830 $ 18,825 $ 15,061 ========= ========== ========= ========= Operating loss: IT Network $ (614) $ (1,617) $(28,779) $ (5,372) Interactive TV (2,759) (2,598) (8,733) (8,053) Corporate $ (2,407) (930) (5,398) (7,011) --------- ---------- --------- --------- Total operating loss $ (5,780) $ (5,145) $ (42,910) $ (20,436) ========= ========== ========= =========
14 15
December 31, 1998 September 30, 1999 ----------------- ------------------- Identifiable assets: IT Network $19,408 $16,784 Interactive TV 8,401 6,868 Corporate 28,780 14,531 ------- ------- Total identifiable assets $56,589 $38,183 ======= =======
On October 30, 1997, the Company purchased certain of the electronic publishing assets of Brite for $35.6 million and certain of the assets of VNN, a unit of Tribune Company, for $9.0 million. Throughout the second quarter of 1998, a significant portion of the customer contracts purchased in the Brite acquisition were cancelled or not renewed. As a result, the Company reviewed the value assigned to the contract rights and certain related intangible assets acquired in the Brite purchase and found them, along with the goodwill associated with the Brite acquisition, to be impaired, resulting in a write-off of $25.9 million in the second quarter of 1998. 9. Subsequent Events On October 25, 1999, the Company announced the successful completion of its consent solicitation relating to certain provisions of the indenture governing its $100 million aggregate principal amount of 12% Senior Secured Notes due 2004 and certain provisions of the certificate of designation governing its $20 million aggregate original liquidation preference of 13 1/2 Senior PIK Preferred Stock due 2007. The purpose of the consent solicitation is to permit Source Media to enter into its proposed joint venture with a subsidiary of Insight Communications Company, Inc. to conduct Source Media's VirtualModem(TM) and Interactive Channel businesses. The consummation of the joint venture is also subject to approval of Source Media's common stockholders at a meeting which is scheduled to take place on November 17, 1999. The changes relating to the bonds and preferred stock will become effective upon consummation of the joint venture, which is expected to occur shortly after approval by the common stockholders and required regulatory approval, if any. At the same time as the formation of the joint venture, Source Media would receive a capital infusion of $12 million, of which Source Media has agreed to place in escrow an amount sufficient to make the $6 million interest payment on the bonds due May 1, 2000. 15 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Unless the context otherwise requires, all references to the "Company" or "Source Media" include Source Media, Inc. and its wholly-owned subsidiaries, IT Network, Inc. ("IT Network"), Interactive Channel, Inc. ("Interactive Channel"), SMI Holdings, Inc. ("Holdings"), and Interactive Channel Technologies Inc., marketed under the name of VirtualModem(TM) ("ICT"). FORWARD LOOKING INFORMATION AND RISK FACTORS The Company or its 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 its various filings with the Securities and Exchange Commission. The Company wishes 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. The Company cautions you that this list of factors does not describe all of the risks of an investment in its common stock. The Company operates in a rapidly changing business environment, and new risk factors continually emerge. The Company cannot predict every risk factor, nor can they assess the impact of all these risk factors on the Company's 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 the Company's actual results. Among the factors that could cause actual results to differ materially from the Company's expectations are the Company's high degree of leverage and its ability to service debt, the need for additional financing, the Company may not have sufficient collateral to repay its indebtedness in full, the potential for a change of control that would require the Company to purchase its notes and preferred stock, historical and projected losses, risks related to the proposed transaction with Insight, access to channels on cable television systems and uncertainty of subscriber acceptance, the uncertainty of a market for interactive television, the availability of programming, our reliance on proprietary technology, the further technical development needed to improve the economics of deploying interactive television to multiple cable systems, a delay in digital roll-out, the integration of technology with digital set-top boxes, competition within the industry, uncertainty of customer acceptance of interactive advertising, the evolving nature of business, anti-takeover effects of a shareholder rights plan, stock volatility, the market price of the Company's common stock, the Company's ability to resolve Year 2000 issues in a timely manner, reliance on key personnel, government regulation and other factors discussed from time to time in the Company's Annual Report on Form 10-K and other Securities and Exchange Commission filings. 16 17 GENERAL Source Media, Inc. operates through its subsidiaries Holdings, IT Network, Interactive Channel and ICT in two business segments: IT Network and Interactive TV. IT Network sells advertising and related support services to clients who sponsor a promotional message with interactive content supplied or otherwise managed by IT Network. IT Network's products and services are distributed primarily through the Company's publisher partners which include Yellow Page directories and daily newspapers. IT Network's products and services are available in North America, Hawaii and the Caribbean. Products and services are also promoted and distributed over radio, television and the Internet. The Company's Interactive TV business consists of the combined efforts of the Interactive Channel and ICT subsidiaries. The Company has designed, fielded and continues to develop 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. On July 29, 1999 the Company announced that it had signed definitive agreements to form a joint venture with a subsidiary of Insight Communications Company, Inc. See further discussion of this transaction in Part II - OTHER INFORMATION, Item 5 - Other Information. NINE MONTHS ENDED SEPTEMBER 30, 1999 AND 1998 Monetary revenues decreased 21% to $13.6 million for the nine months ended September 30, 1999 from $17.3 million for the same period in 1998. This decrease is primarily due to decreases of $2.1 million in system management and information services and $1.4 million in advertising sales. In addition, the 1998 period included $0.2 million of revenues associated with an Interactive Channel test market. There have been no such revenues in 1999. The decrease in system management and information services is attributable to increased industry competition, customers migrating to their own systems and Year 2000 hardware issues at customers. Advertising sales decreased primarily due to a reorganization of the sales department and delays in implementing new products in 1999. Monetary cost of sales increased 12% to $9.8 million for the nine months ended September 30, 1999 from $8.8 million for the same period 1998 primarily as a result of $1.6 million of expense recognized for anticipated payments to customers for unmet sales guarantees and $0.3 million of cost related to new products in 1999, partially offset by savings of $0.5 million in page costs related to decreased advertising sales and other operational savings of $0.4 million. Nonmonetary revenues and nonmonetary cost of sales decreased 4% to $1.4 million for the nine months ended September 30, 1999. Nonmonetary sales accounted for 10% of revenues 17 18 for the nine months ended September 30, 1999 and 8% of the revenues for the nine months ended September 30, 1998. SG&A expenses increased 2% for the nine months ended September 30, 1999 to $18.2 million from $17.8 million for the same period in 1998. Increased expenses were incurred for: (i) $1.8 million in legal and professional costs incurred in connection with the proposed Prevue joint venture that were expensed after the termination of the proposed Prevue transaction; (ii) $0.6 million of legal expense attributable to other litigation (described in Note 4 in the Notes to Consolidated Financial Statements); (iii) $0.6 million of accrued severance to certain employees. These increases were offset by decreases of $0.9 million for non-cash variable compensation expense for certain stock options granted to certain employees in excess of share authorized, the elimination of $0.7 million of transitional cost related to the integration of acquired businesses incurred in 1998, decreased trade advertising expense of $0.3 million in 1999 and other SG&A savings of $0.7 million. Impairment of intangible assets included in the prior year amount relates to $25.9 million of write-offs of certain intangible assets described in the Company's Form 10-K. Amortization of intangible assets decreased 27% to $3.7 million for the nine months ended September 30, 1999 from $5.1 million for the same period in 1998 due to a lower intangible asset balance. Research and development expenses decreased 12% to $2.3 million for the nine months ended September 30, 1999 from $2.6 million for the same period in 1998 as a result of reduced development requirements of launched products. Interest expense remained unchanged at $9.6 million for the nine months ended September 30, 1999 and 1998. 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 decreased 63% to $0.6 million for the nine months ended September 30, 1999 from $1.6 million for the same period in 1998 due to lower investment and cash balances as a result of debt interest payments and normal operating expenditures. Preferred Stock dividends of $1.4 million and $2.3 million for the nine months ended September 30, 1999 and 1998, respectively, relate 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 shares issued resulting in a lower dividend expense recognized in the current year. THREE MONTHS ENDED SEPTEMBER 30, 1999 AND 1998 Monetary revenues decreased 33% to $4.3 million for the three months ended September 30, l999 from $6.3 million for the same period in 1998. This decrease is primarily due to 18 19 decreases of $1.3 million in advertising sales and $0.7 million in information services and system management. The decrease in system management and information services is attributable to increased industry competition, customers migrating to their own systems and Year 2000 hardware issues at customers. Advertising sales decreased primarily due to a reorganization of the sales department and delays in implementing new products. Monetary cost of sales decreased 11% to $3.1 million for the three months ended September 30, 1999 from $3.5 million for the same period in 1998 as a result of a $0.3 million reduction in page costs related to the decreased advertising sales, $0.3 million of operating efficiencies offset by $0.2 million of expense recognized for anticipated payments to customers for unmet sales guarantees on various advertising contracts. Nonmonetary revenues and nonmonetary cost of sales increased 47% to $0.6 million for the three months ended September 30, 1999. Nonmonetary sales accounted for 11% of revenues for the three months ended September 30, 1999 compared to 6% of revenues for the same period in 1998. SG&A expenses decreased 37% to $4.1 million for the three months ended September 30, 1999 from $6.5 million for the same period in 1998. The decrease is primarily due to a $1.4 million decrease in non-cash variable compensation expense, $0.4 million of savings in compensation related expenses and $0.6 million in cost reductions in other administrative expenses. Amortization of intangible assets remained unchanged at $1.2 million for the three months ended September 30, 1999. Research and development expenses decreased 15% to $0.8 million for the three months ended September 30, 1999 from $0.9 million for the three months ended September 30, 1998, primarily due to reduced development requirements of launched products. Interest expense remained unchanged at $3.2 million for the three months ended September 30, 1999 and 1998. 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 decreased 77% to $0.1 million for the three months ended September 30, 1999 from $0.5 million for the same period in 1998 due to lower investment and cash balances as a result of debt interest payments and normal operating expenditures. Preferred Stock dividends of zero and $0.7 million for the three months ended September 30, 1999 and 1998, respectively, relate 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 shares issued resulting in a lower dividend expense recognized in the current year. 19 20 LIQUIDITY AND CAPITAL RESOURCE Since its inception, the Company has experienced substantial operating losses and net losses as a result of its efforts to develop, deploy and support IT Network and develop, conduct trials and commercially launch Interactive TV. As of September 30, 1999, the Company had an accumulated deficit of $178.4 million and had used cumulative net cash in operations of $89.1 million. The difference at September 30, 1999, 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. The effect of the lost customers associated with the Brite acquisition will continue to have a negative impact on the Company's revenues and profitability. The Company will continue to incur operating losses at least through 1999, although it expects that cash generated in IT Network operations excluding related interest expense will be sufficient to meet IT Network's operating requirements through 1999. Any launch of the Company's television products and services may require additional expenditures, which may require the Company to raise additional capital. The definitive agreements between the Company and Insight, provide, among others, the following benefits to the Company: (i) at closing, the Interactive TV research and development costs and certain other costs would become costs of the joint venture; (ii) at closing, Insight would pay the Company $12.0 million cash for 842,105 shares of common stock, and (iii) at closing, Insight would receive warrants which Insight could exercise at any time within five years to buy approximately 4.6 million shares of the Company's common stock at $20.00 per share, which if fully exercised, would result in proceeds of approximately $92.0 million and give Insight an approximate 20% ownership of the Company. Requirements for closing the Insight transaction include shareholder, bondholder and potential regulatory approval. Bondholder and preferred stockholder approval has been obtained as of October 25, 1999. The meeting to obtain common stockholder approval is scheduled for November 17, 1999. Since its inception, the Company has financed its operations primarily with $156.6 million raised from various financing activities, including the incurrence of debt and issuance of the Company's common stock and preferred stock. In October 1997, the Company issued $100.0 million of Senior Secured Notes (the "Notes") and $20.0 million of preferred stock. The interest escrow account created pursuant to the indenture has been and will be 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 and May 1, 1999. The Company's primary source of liquidity is its cash, cash equivalents and restricted investments, which totaled $11.8 million at September 30, 1999. This cash position consisted of $6.0 million held in escrow for the November 1, 1999 interest payment and $5.8 million of cash available for operations. The Company's first interest payment not currently held in escrow is due May 1, 2000. The Company currently believes its resources will be sufficient to meet the Company's anticipated cash needs for working capital and other capital expenditures related to the Company's business and operations through the fourth quarter of 1999. Upon the closing of the 20 21 Insight transaction, the cost of Interactive TV's operations will be funded by the joint venture. Additionally, the Company will receive $12.0 million cash from the sale of common stock related to the Insight transaction which is expected to adequately fund the Company's continuing operations for approximately twelve months and the interest payment on its debt, due on May 1, 2000. If the Insight transaction is not approved the Company would be required to seek alternative financing. There can be no assurance that the Company will be able to obtain such financing. The Company's future capital requirements will depend on many factors, including, but not limited to the following factors, some of which are outside the Company's control: (i) the operating results of IT Network, including the Company's ability to successfully integrate its acquired businesses into its existing business, and to retain and grow its customer base, along with customer acceptance of Internet advertising; (ii) the success and timing of the development, introduction and deployment of Interactive TV; (iii) the extent to which the Company is able to generate revenues from Interactive TV; (iv) the number of file servers and other equipment which the Company purchases in support of Interactive TV; (v) the levels of advertising expenditures necessary to increase awareness of Interactive TV; (vi) the extent of market acceptance of the Company's products; (vii) potential acquisitions or asset purchases; (viii) the deployment of digital set-top boxes incorporating the Company's technology; (ix) the capital required to address the Company's Year 2000 issue; (x) the proposed transaction with Insight and (xi) competitive factors. YEAR 2000 DISCLOSURES The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs or hardware that have date-sensitive software or embedded chips may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. Based on recent assessments, the Company determined that it will be required to modify or replace portions of its software and certain hardware so that those systems will properly utilize dates beyond December 31, 1999. The Company presently believes that with modifications or replacements of existing software and certain hardware, the Year 2000 issue can be mitigated. However, if such modifications and replacements are not made, or are not completed in a timely manner, the Year 2000 issue could have a material impact on the operations of the Company. The Company's plan to resolve the Year 2000 issue involves the following four phases: assessment, remediation, testing and implementation. To date, the Company has completed its assessment of all systems that could be significantly affected by the Year 2000. The Company's three operating subsidiaries, ICT, Interactive Channel and IT Network, as well as the corporate unit were included in the assessment. The assessment indicated that most of the Company's significant information technology systems could be affected. That assessment also indicated that software and hardware (embedded chips) used in the IT Network's interactive voice response systems also are at risk (hereinafter referred to as operating systems). In addition, the Company 21 22 is gathering information about the Year 2000 compliance status of its significant suppliers and subcontractors and is continuing to monitor their compliance. Regarding its information technology, the Company is approximately 99% complete on the remediation phase and expects to complete software reprogramming and replacement for all systems no later than November 30, 1999. Once software is reprogrammed or replaced for a system, the Company will begin testing and implementation. These phases run concurrently for different systems. To date, the Company has completed all of its testing and has implemented approximately 99% of its remediated systems. Completion of the testing phase for all significant systems has occurred and all remediated systems are expected to be fully tested and implemented by November 30, 1999. The Company has initiated the remediation phase of its operating equipment. The remediation of operating equipment is significantly more difficult than the remediation of the information technology systems because some of the software operating systems are no longer supported by the manufacturers of that equipment. Testing of this equipment is also more difficult than the testing of the information technology systems; the Company is approximately 95% complete with the testing of its remediated operating equipment. Once testing is complete, the operating equipment will be ready for immediate use. The Company expects to complete its remediation of operating equipment by November 30, 1999. Testing and implementation of affected equipment is expected to be completed by November 30, 1999. The Company is in the process of working with third party vendors to ensure that the Company's systems that interface directly with third parties are Year 2000 compliant by December 31, 1999. The Company has completed 100% of its remediation efforts on these systems and is 100% complete with the testing phase. Implementation has been completed. The Company is querying its significant suppliers and subcontractors that do not share information systems with the Company (external agents). To date, the Company is not aware of any external agent with a Year 2000 issue that would materially impact the Company's results of operations, liquidity, or capital resources. However, the Company has no means of ensuring that external agents will be Year 2000 ready. The inability of external agents to complete their Year 2000 resolution process in a timely manner could materially impact the Company. The effect of non-compliance by external agents is not determinable. Additionally, the Company is exposed to the risk that customers may elect to discontinue receiving telephone information services due to the customer's equipment not being upgraded to address Year 2000 problems, although various hardware and software solutions exist. Certain customers have discontinued service which has resulted in a loss of revenues to the Company. Further losses of revenue may occur. The Company will utilize both internal and external resources to reprogram, or replace, test, and implement the software and operating equipment for Year 2000 modifications. The total cost of the Year 2000 project is estimated at $1.0 million and is being funded through operating cash flows. To date, the Company has incurred expenses of approximately $0.7 million, related to all phases of the Year 2000 project. Of the total remaining project costs, approximately $0.2 22 23 million is attributable to the purchase of new software and operating equipment, which will be capitalized. The remaining $0.1 million relates to repair of hardware and software that will be expensed as incurred. Management of the Company believes it has an effective program in place to resolve the Year 2000 issue in a timely manner. The Company has not yet completed all necessary phases of the Year 2000 program. There can be no assurance that the Company's efforts to solve its potential Year 2000 problems will be successful, or even partially successful. In the event that the Company does not complete any additional phases, the Company may be unable to take customer orders, provide services and products, invoice customers or collect payments. In addition, disruptions in the economy generally resulting from Year 2000 issues could also materially adversely affect the Company. The Company could be subject to litigation for computer systems product failure, equipment shutdown or failure to properly date business records. The amount of potential liability and lost revenue cannot be reasonably estimated at this time. The Company has contingency plans for certain critical applications and is working on such plans for others. These contingency plans involve manual workarounds, telecommunication alternatives, staff adjustments and other appropriate actions. NET OPERATING LOSS CARRYFORWARDS At December 31, 1998, Holdings had net operating loss carryforwards of approximately $87.4 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. Consequently, the Company's utilization of a portion of the net operating losses is limited to approximately $9.0 million in a given year. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The Company is exposed to changes in interest rates related primarily to its Notes and Preferred Stock arrangements. Under its current policies, the Company does not use interest rate derivative instruments to manage exposure to interest rate changes. At September 30, 1999, the Company had Notes outstanding of $100.0 million, due November 1, 2004, which bear interest at a fixed rate of 12% and Preferred Stock outstanding of $24.4 million due November 1, 2007, which bears interest at a fixed rate of 13 1/2%. The fair value of the Notes and Preferred Stock at September 30, 1999 was approximately $38.0 million and $5.0 million, respectively, based upon dealer quoted market prices. 23 24 PART II - OTHER INFORMATION Item 1 - Legal Proceedings Interactive Channel Technologies Inc. and SMI Holdings, Inc. filed a patent infringement suit against Worldgate Communications, Inc. in federal district court in Delaware in May 1998. In June 1998, Worldgate filed a Counterclaim against plaintiffs and Source Media, Inc. for, among other things, unfair competition, interference with contract, and trade secret misappropriation. The Counterclaim defendants have denied the allegations in the Counterclaim and on July 27, 1998 filed a motion to dismiss certain of Worldgate's claims. The motion was denied by Order of the Court dated May 17, 1999. The Court held a status conference on May 13, 1999. The following deadlines for the disposition of the case were set by the Court: Joinder of Parties and Amendment of Pleadings December 1, 1999 Close of Fact Discovery May 12, 2000 Close of Expert Discovery July 14, 2000 Deadline for Dispositive Motions July 21, 2000 Trial November 27, 2000 Pursuant to the Scheduling Order, limited discovery commenced on August 16, 1999. Full-scale discovery commenced on October 1, 1999. Both parties have propounded discovery requests, responses to which are due on or before December 1, 1999. On July 17, 1998, IT Network, Inc. ("ITN") filed a lawsuit against a former employee of Brite Voice Systems, Inc. ("Brite"), Michael Shell ("Shell"), the two companies he founded Interactive Media Services, Inc. ("IMS") and Interactive Information Services, LLC ("IIS"), and a third company called Talking Directories, Inc. ("TDI"). The lawsuit was filed in the Western District of Michigan and alleged two causes of action, one for the copyright infringement against all of the defendants arising out of the defendants' alleged use of ITN's 1997 BDR Audio Guide (the "Catalogue") and the thousands of narrative scripts that correspond to the subject matter categories contained in the Catalogue (the "Scripts"), and a second for breach of contract against TDI arising out of TDI's alleged wrongful termination of its information services contract with ITN. As of September 30, 1999, the litigation was settled with respect to all defendants. A total of fourteen class action complaints were filed against Source Media, Inc. ("SMI") and certain of its 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 and Rule 10b-5 of the accompanying regulations. The fourteen complaints were consolidated by Judge Buchmeyer into the first filed case, Hartsell, et al. v. Source Media, Inc., et al., Civil Action No. 398-CV-1980-R (filed August 21, 1998), on October 9, 1998. Plaintiffs filed a motion for the appointment of lead plaintiff and lead plaintiffs' counsel on October 20, 1998. Plaintiff proposed the appointment of three law firms to serve as "Co-Lead Counsel," Weiss & Yourman, Abbey, Gardy & Squitieri, and Milberg Weiss Bershad Hynes & Lerach, LLC. On November 12, 1998, defendants filed a statement of non-opposition to the plaintiffs' motion. The Court granted plaintiffs' motion on January 5, 1999. 24 25 Pursuant to an Order entered by the Court on February 24, 1999, plaintiffs' time for filing the consolidated amended complaint was extended from February 24, 1999 to March 3, 1999. Plaintiffs filed their amended complaint on March 3, 1999. Defendants filed a motion to dismiss on April 19, 1999, plaintiffs filed an opposition to the motion on May 24, 1999, and defendants filed a reply brief on June 12, 1999. A hearing on the motion to dismiss was held on July 15, 1999. By Order dated July 15, 1999, the Court denied defendants' motion. On July 26, 1999, defendants filed an Application For Immediate Appellate Review Under 28 U.S.C. Section 1292(b) concerning two issues central to the Court's denial of defendants' motion to dismiss. Plaintiffs filed an opposition on or about August 13, 1999. By Order dated August 24, 1999, the Court denied defendants' motion. On August 16, 1999, plaintiffs filed a complaint against Ernst & Young LLP, Source Media, Inc.'s outside accountants, alleging violations of the federal securities laws (the "E&Y Complaint"). The facts and circumstances underlying the E&Y Complaint are similar to those underlying the amended complaint. By Order dated August 31, 1999, the Court consolidated the E&Y Complaint with the amended complaint. Ernst & Young moved to dismiss the E&Y Complaint on September 21, 1999, plaintiffs filed an opposition to the motion on October 28, 1999 and defendants' reply brief is due on November 19, 1999. The Court held a status conference on October 8, 1999. In light of the E&Y Complaint and the resurrection of the mandatory discovery stay as to Ernst & Young, the Court continued the trial date in the case until October 2, 2000. Plaintiffs and defendants have submitted alternative scheduling proposals to the Court regarding deadlines for discovery and dispositive motions. To date, the Court has not issued a revised scheduling order. On October 27, 1999, plaintiffs filed a Summary Notice of Pendency of Class Action advising class members of the pendency of the litigation. Plaintiffs filed a proposed Order Approving Class Notices on November 5, 1999. The proposed Order has not yet been signed by the Court. On October 6, 1998, Advanced Interactive, Inc. filed a complaint in U.S. District Court for the Northern District of Illinois, Eastern Division, against ICT 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 America, 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 "Advanced Interactive Defendants"). Advanced Interactive alleges that ICT infringed two claims of one of its patents by manufacturing, using and/or selling or offering to sell "Sourceware(TM) and ChannelLink(TM)". The same allegation is made against each Advanced Interactive Defendant for its particular product or service. The Plaintiff seeks damages, but makes no claims against the patents of ICT or any other Advanced Interactive Defendant. ICT, 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 25 26 Electronics Corp., Sharp Corp. and the Toshiba Defendants. On May 12, 1999 the court denied Advanced Interactive's Motion for Summary Judgement of Infringement. The court has not yet considered the Advanced Interactive Defendant's collective Motion for Partial Summary Judgment. The Company believes this case is totally without merit and intends to vigorously defend itself. On August 3, 1999, the Company announced that it had filed an action in the District Court of Dallas County, Texas against TV Guide, Inc. for breach of a Non-Disclosure Agreement entered into in September 1998. The petition sought damages of approximately $60 million representing the decline in share value caused by improper statements made by TV Guide and an injunction precluding TV Guide from any further violations of the Non-Disclosure Agreement. The parties entered into a settlement agreement and release on August 31, 1999 pursuant to which TV Guide affirmed and agreed to honor the terms of the Non-Disclosure Agreement. 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 are not expected to have a material adverse affect on the Company. Further, the Company is party to ordinary routine litigation, none of which is expected to have a material adverse effect on the Company's results of operations or its financial condition. Item 2 - Changes in Securities and Use of Proceeds - not applicable Item 3 - Defaults Upon Senior Securities - not applicable Item 4 - Submission of Matters to a Vote of Security Holders - not applicable Item 5 - Other Information As part of the Company's review of its booking performance against customer sales guarantees, the Company anticipates a shortfall on several contracts. In connection with these guarantees, the Company has recorded a $0.2 million expense in the third quarter for total expense of $1.6 million for the nine months ended September 30, 1999. The Company has employment agreements with two executives. The agreements provide that the Company will pay a base salary amount and grant stock options over a set term to the employees. In the event of a termination without cause, the Company remains obligated to make certain payments as defined in the agreements. One contract terminates in 2001 and the other in 2002. On July 29, 1999, Source Media, Inc. and a wholly-owned subsidiary of Insight Communications Company, Inc. ("Insight") entered into definitive agreements to form a joint venture ("Newco") to conduct all the lines of business currently conducted by the Company relating to its "VirtualModem" and "Interactive Channel" products and businesses (the "Transferred Businesses"). The completion of the transaction is subject to the parties' fulfillment of certain closing conditions. 26 27 Pursuant to the terms of a Common Stock and Warrants Purchase Agreement (the "Purchase Agreement"), upon the formation of Newco, Insight will acquire 842,105 shares of common stock of the Company, representing approximately 6% of the issued and outstanding stock of the Company, for a purchase price of $12 million in cash ($14.25 per share). The Company will also issue to Insight five-year warrants to acquire up to an additional 4,596,786 shares of the Company's common stock at an exercise price of $20.00 per share, representing, together with the above-mentioned 842,105 shares of common stock, approximately 20% of the Company's fully diluted equity. The Purchase Agreement contains provisions to protect Insight's interest in the Company, including preemptive rights and board representation. Initially, upon the closing of the transaction, the Company's board of directors would consist of seven members, three of whom would be designated by Insight. Under the terms of a Contribution Agreement (the "Contribution Agreement"), Newco would be capitalized initially with a $13 million equity infusion by Insight and with the Company's asset contribution described below. Both Insight and the Company will receive a 50% equity ownership in Newco in consideration for their contribution. The Company will assign all its right, title and interest in and to the intellectual property that has application in the VirtualModem and Interactive Channel businesses to Newco, to the extent assignable, and will grant to Newco an exclusive, perpetual, royalty free, irrevocable, worldwide license (the "Newco License"), with the right to sublicense, to all of the intellectual property not freely assignable by the Company, to the extent such intellectual property permits the grant of licenses, except that in each case the intellectual property covered by such assignment and license will specifically exclude any television programming content that is developed in the future by the Company or any of its subsidiaries. Newco will grant back to the Company a non-exclusive, perpetual, royalty free, irrevocable worldwide license of the intellectual property used in the Company's businesses other than the Transferred Businesses. In addition, the Company will transfer to Newco all the equipment, intangible property and data, contract rights, inventory and accounts receivable which have use in the Transferred Businesses excluding any routine, general or non-unique assets. The Company will serve as the manager of Newco and will manage the day-to-day operations of Newco. However, certain special actions by Newco would require approval of a four-member management committee. The Company and Insight would have equal representation on the management committee. Such special actions would include material deviations from Newco's business plan and budget, issuance of additional equity, distributions to equity holders, asset sales and other significant matters. The management agreement to be entered into between the Company and Insight on the closing date will set forth the terms under which the business of Newco will be conducted. Unless agreed to otherwise, the Company will continue to provide all necessary services and business functions for Newco and will be reimbursed for the related costs and expenses without any mark-up. The management agreement will also contain provisions granting Newco the sole and exclusive ownership of any inventions, improvements or modifications, including any related intellectual property rights, which are developed by employees, officers or other parties associated with the Company in the performance of the management agreement. 27 28 The operating agreement to be entered into on closing by the Company and Insight contemplates a "buy-sell" arrangement whereby either party, following the fifth anniversary of the joint venture, may send to the other party a notice specifying the value that the notifying party assigns to 100% of the equity ownership of Newco. The notified party is then required to either purchase the entire equity ownership from the notifying party or sell its entire equity ownership to the notifying party, in each case using the valuation set forth in the notice. The operating agreement provides for certain transfer restrictions relating to Newco interests, drag-along and tag-along rights with respect to such interests and rights upon a change in control of the Company. The definitive agreements contemplate an affiliation agreement between Newco and Insight relating to the carriage of the Interactive Channel over Insight's cable television systems, as well as a license agreement granting Insight an irrevocable license to use Newco's intellectual property in connection with such cable television systems. Until the date of the closing, the Company is prohibited from participating in any substantive negotiations with any person or entity, other than Insight or its affiliates, concerning a business combination, the disposition of any of its material assets or, with certain exceptions, the issuance of any of its securities. All of the obligations of Insight are guaranteed by its parent, Insight Communications Company, Inc. Upon the completion of the transaction with Insight substantially on the terms set forth in this Form 10-Q, the Company's business will be subject to additional risks, including the dilutive effect of shares and warrants to be issued to Insight and the ability of Newco to obtain distribution and negotiate licensing arrangements for the Interactive Channel. The consummation of the transaction will be subject to the approval of the transaction from the Company's common stockholders, as well as from the holders of its long-term debt and preferred stock and, any potentially required clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976. The Company obtained approval of the Bondholders and Preferred Stockholders on October 25, 1999. The Company give no assurances that the remaining conditions will be met and accordingly, that will consummate a transaction with Insight on the terms contained in this Form 10-Q, or at all. Item 6 - Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 27 - Financial Data Schedule (b) Reports on Form 8-K during the three months ended September 30, 1999. None. 28 29 SIGNATURES 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 15, 1999 By: /s/ PAUL TIGH ----------------- ------------------------------------------ Paul Tigh Chief Financial Officer and Treasurer (Principal Financial Officer and Duly Authorized Officer) 29 30 EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION - ------- ----------- 27 Financial Data Schedule
EX-27 2 FINANCIAL DATA SCHEDULE
5 1,000 9-MOS DEC-31-1999 JAN-01-1999 SEP-30-1999 5,768 0 1,491 0 0 14,767 12,300 8,765 38,183 13,927 100,000 18,061 0 14 (96,836) 38,183 15,061 15,061 11,263 24,234 (642) 0 9,621 (29,414) 0 0 0 0 0 (30,848) (2.32) (2.32)
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