2nd Quarter Form 10Q 04-12-05
 


 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended February 26, 2005

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from __________ to __________

Commission file no. 1-11107


FRANKLIN COVEY CO.

(Exact name of registrant as specified in its charter)

 
Utah
87-0401551
 
 
(State of incorporation)
(I.R.S. employer identification number)
 
       
 
2200 West Parkway Boulevard
84119-2099
 
 
Salt Lake City, Utah
(Zip Code)
 
 
(Address of principal executive offices)
   
       
 
Registrant’s telephone number,
   
 
Including area code
(801) 817-1776
 


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
o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes
o 
No
x

Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock as of the latest practicable date:
20,135,743 shares of Common Stock as of April 4, 2005
 



 
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS


FRANKLIN COVEY CO.

CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)

   
February 26,
2005
 
August 31,
2004
 
   
(unaudited)
 
ASSETS
             
Current assets:
             
Cash, cash equivalents, and short-term investments
 
$
47,262
 
$
41,904
 
Accounts receivable, less allowance for doubtful  accounts of $1,356 and $1,034
   
18,290
   
18,636
 
Inventories
   
23,423
   
23,693
 
Other current assets
   
4,656
   
5,794
 
Total current assets
   
93,631
   
90,027
 
               
Property and equipment, net
   
36,389
   
40,584
 
Intangible assets, net
   
85,426
   
87,507
 
Other long-term assets
   
9,045
   
7,593
 
   
$
224,491
 
$
225,711
 
               
LIABILITIES AND SHAREHOLDERS’ EQUITY
             
Current liabilities:
             
Current portion of long-term debt
 
$
120
 
$
120
 
Accounts payable
   
8,716
   
14,018
 
Outsourcing contract costs payable
   
4,059
   
4,914
 
Income taxes payable
   
7,416
   
5,903
 
Accrued liabilities
   
29,391
   
31,244
 
Total current liabilities
   
49,702
   
56,199
 
               
Long-term debt, less current portion
   
1,341
   
1,350
 
Other liabilities
   
1,722
   
1,550
 
Total liabilities
   
52,765
   
59,099
 
               
Shareholders’ equity:
             
Preferred stock - Series A, no par value; convertible into common stock at $14 per    share; 4,000 shares authorized, 873 shares  issued; liquidation preference totaling $89,530
   
87,203
   
87,203
 
Common stock - $0.05 par value; 40,000 shares authorized, 27,056 shares issued
   
1,353
   
1,353
 
Additional paid-in capital
   
194,960
   
205,585
 
Accumulated deficit
   
(186
)
 
(8,798
)
Deferred compensation on restricted stock grants
   
(814
)
 
(732
)
Accumulated other comprehensive income
   
1,111
   
1,026
 
Treasury stock at cost, 6,615 and 7,028 shares
   
(111,901
)
 
(119,025
)
Total shareholders’ equity
   
171,726
   
166,612
 
   
$
224,491
 
$
225,711
 
               


See notes to condensed consolidated financial statements.


FRANKLIN COVEY CO.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)

   
Quarter Ended
 
Two Quarters Ended
 
                   
   
February 26,
2005
 
February 28,
2004
 
February 26,
2005
 
February 28,
2004
 
   
(unaudited)
 
(unaudited)
 
Net sales:
                         
Products
 
$
55,175
 
$
57,009
 
$
99,226
 
$
108,785
 
Training and services
   
27,348
   
21,706
   
52,401
   
44,961
 
     
82,523
   
78,715
   
151,627
   
153,746
 
Cost of sales:
                         
Products
   
24,733
   
26,898
   
44,817
   
51,562
 
Training and services
   
7,725
   
7,192
   
15,586
   
15,033
 
     
32,458
   
34,090
   
60,403
   
66,595
 
Gross margin
   
50,065
   
44,625
   
91,224
   
87,151
 
                           
Selling, general, and administrative
   
38,787
   
39,410
   
74,440
   
79,426
 
Depreciation
   
2,320
   
3,222
   
4,498
   
6,813
 
Amortization
   
1,043
   
1,043
   
2,087
   
2,087
 
Income (loss) from operations
   
7,915
   
950
   
10,199
   
(1,175
)
                           
Interest income
   
165
   
141
   
282
   
227
 
Interest expense
   
(29
)
 
(56
)
 
(66
)
 
(167
)
Income (loss) before provision for income taxes
   
8,051
   
1,035
   
10,415
   
(1,115
)
Provision for income taxes
   
(965
)
 
(803
)
 
(1,803
)
 
(1,833
)
Net income (loss)
   
7,086
   
232
   
8,612
   
(2,948
)
Preferred stock dividends
   
(2,184
)
 
(2,184
)
 
(4,368
)
 
(4,368
)
Net income (loss) available to common shareholders
 
$
4,902
 
$
(1,952
)
$
4,244
 
$
(7,316
)
                           
Net income (loss) available to common
shareholders per share (Note 11):
                         
Basic
 
$
.19
 
$
(.10
)
$
.16
 
$
(.37
)
Diluted
 
$
.19
 
$
(.10
)
$
.16
 
$
(.37
)
                           
Weighted average number of common shares:
                         
Basic
   
19,880
   
19,940
   
19,790
   
19,953
 
Diluted
   
19,940
   
19,940
   
19,804
   
19,953
 

 
See notes to condensed consolidated financial statements.


FRANKLIN COVEY CO.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
   
Two Quarters Ended
 
   
February 26,
2005
 
February 28,
2004
 
   
(unaudited)
 
Cash flows from operating activities:
             
Net income (loss)
 
$
8,612
 
$
(2,948
)
Adjustments to reconcile net income (loss) to net cash used for operating activities:
             
Depreciation and amortization
   
7,633
   
9,694
 
Loss (gain) on disposal of assets
   
32
   
(48
)
Restructuring cost reversal
   
(306
)
 
-
 
Amortization of deferred compensation
   
371
   
14
 
Compensation related to CEO common stock grant
   
404
   
-
 
Changes in assets and liabilities:
             
Decrease in accounts receivable, net
   
627
   
3,685
 
Decrease in inventories
   
365
   
10,224
 
Decrease (increase) in other assets
   
(192
)
 
1,937
 
Decrease in accounts payable, outsourcing contract costs
payable, and accrued liabilities
   
(8,222
)
 
(20,420
)
Increase in other long-term liabilities
   
169
   
155
 
Increase in income taxes payable
   
1,530
   
1,018
 
Net cash provided by operating activities
   
11,023
   
3,311
 
               
Cash flows from investing activities:
             
Purchases of property and equipment
   
(1,120
)
 
(1,923
)
Purchases of short-term investments
   
(10,653
)
 
(13,430
)
Sales of short-term investments
   
8,963
   
2,500
 
Proceeds from sale of property and equipment
   
-
   
1,554
 
Net cash used for investing activities
   
(2,810
)
 
(11,299
)
               
Cash flows from financing activities:
             
Principal payments on long-term debt
   
(62
)
 
(44
)
Proceeds from sales of common stock from treasury
   
35
   
83
 
Purchase of treasury shares
   
(22
)
 
(85
)
Payment of preferred stock dividends
   
(4,368
)
 
(4,368
)
Net cash used for financing activities
   
(4,417
)
 
(4,414
)
               
Effect of foreign exchange rates on cash and cash equivalents
   
(128
)
 
2
 
Net increase (decrease) in cash and cash equivalents
   
3,668
   
(12,400
)
Cash and cash equivalents at beginning of the period
   
31,174
   
41,916
 
Cash and cash equivalents at end of the period
 
$
34,842
 
$
29,516
 
               
Supplemental disclosure of cash flow information:
             
Cash paid for interest
 
$
53
 
$
225
 
Cash paid for income taxes
 
$
602
 
$
444
 
               
Non-cash investing and financing activities:
             
Accrued preferred stock dividends
 
$
2,184
 
$
2,184
 
Issuance of restricted stock as deferred compensation
 
$
486
 
$
829
 
               
 

See notes to condensed consolidated financial statements.
 
 
 

FRANKLIN COVEY CO.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
 

NOTE 1 - BASIS OF PRESENTATION

Franklin Covey Co. (the Company) provides integrated consulting, training, and performance enhancement solutions to organizations and individuals in productivity, leadership, strategy execution, sales force effectiveness, effective communications, and other areas. Each integrated solution may include components of training and consulting, assessment, and other application tools that are generally available in paper-based or electronic formats. The Company’s products and services are available through professional consulting services, public workshops, retail stores, catalogs, and the Internet at www.franklincovey.com. The Company’s historically best-known offerings include the FranklinCovey PlannerTM, courses based on the best-selling book, The Seven Habits of Highly Effective People, and the productivity workshop entitled, “Focus: Achieving Your Highest Priorities.” The Company’s latest offerings include facilitated work sessions, a course entitled “The 4 Disciplines of Execution”, and its assessment tool, “xQ” (Execution Quotient).

The accompanying unaudited condensed consolidated financial statements reflect, in the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position and results of operations of the Company as of the dates and for the periods indicated. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to Securities and Exchange Commission (SEC) rules and regulations. The information included in this quarterly report on Form 10-Q should be read in conjunction with the financial statements and related notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended August 31, 2004.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

The Company utilizes a modified 52/53-week fiscal year that ends on August 31 of each year. Corresponding quarterly periods generally consist of 13-week periods that end on November 27, 2004, February 26, 2005, and May 28, 2005 during fiscal 2005. Under the modified 52/53-week fiscal year, the quarter ended February 26, 2005 had the same number of business days as the quarter ended February 28, 2004. However, the two quarters ended February 26, 2005 had two fewer business days than the two quarters ended February 28, 2004.

The results of operations for the quarter ended February 26, 2005 are not indicative of results expected for the entire fiscal year ending August 31, 2005.

Certain reclassifications have been made to the fiscal 2004 financial statements to conform with the current period presentation, including $10.7 million of cash equivalents at August 31, 2004 that were reclassified to short-term investments in order to conform to fiscal 2005 financial statement presentation.



NOTE 2 - ACCOUNTING FOR STOCK-BASED COMPENSATION

The Company accounts for its stock-based compensation and awards using the intrinsic-value method of accounting as outlined in Accounting Principles Board (APB) Opinion 25 and related interpretations. Under the intrinsic-value methodology, no compensation expense is recognized for stock option awards granted at, or above, the fair market value of the stock on the date of grant. Accordingly, no compensation expense has been recognized for the Company’s stock option plans or employee stock purchase plan in its condensed consolidated statements of operations, except as disclosed below. Had compensation expense for the Company’s stock option plans and employee stock purchase plan been determined in accordance with the fair value approach as defined by Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, the Company’s net income (loss) available to common shareholders and corresponding basic and diluted earnings per share would have been the following (in thousands, except per share data):
 

 
 
Quarter Ended
 
Two Quarters Ended
 
   
February 26,
2005
 
February 28,
2004
 
February 26,
2005
 
February 28,
2004
 
Net income (loss) available to common shareholders, as reported
 
$
4,902
 
$
(1,952
)
$
4,244
 
$
(7,316
)
Fair value of stock-based compensation, net of tax
   
(1,915
)
 
(193
)
 
(2,102
)
 
(387
)
Net income (loss) available to common shareholders, pro forma
 
$
2,987
 
$
(2,145
)
$
2,142
 
$
(7,703
)
                           
Basic earnings (loss) per share, as reported
 
$
.19
 
$
(.10
)
$
.16
 
$
(.37
)
Diluted earnings (loss) per share, as reported
 
$
.19
 
$
(.10
)
$
.16
 
$
(.37
)
                           
Basic earnings (loss) per share, pro forma
 
$
.11
 
$
(.11
)
$
.08
 
$
(.39
)
Diluted earnings (loss) per share, pro forma
 
$
.11
 
$
(.11
)
$
.08
 
$
(.39
)

 
In connection with changes in the Company’s Chief Executive Officer (CEO) compensation plan (Note 14), the CEO was granted 187,000 shares of fully-vested Company common stock and 225,000 shares of restricted stock (RSA) as a long-term incentive during the quarter ended February 26, 2005. In addition, the Company accelerated the vesting of the CEO’s 1.6 million stock options with an exercise price of $14.00 per share. The impact of these stock-based awards on the Company’s financial statements as of and for the period ended February 26, 2005 was as follows: 

·  
Fully-Vested Stock Award - Based upon guidance in APB Opinion 25, the fair value of the fully vested stock award of 187,000 shares of common stock was calculated based upon the fair value of the Company’s common stock at the measurement date. The fully-vested stock award was valued at $2.16 per share, which was the closing market price of the Company’s common stock on the measurement date and resulted in $0.4 million of expense that was included as a component of selling, general, and administrative expense. The cost of the common stock issued from treasury was $3.2 million and the difference between the cost of the treasury stock and fair value of the award, which totaled $2.8 million, was recorded as a reduction of additional paid-in capital.

·  
Restricted Stock Award - The Company awarded the CEO 225,000 shares of restricted common stock as a long-term incentive consistent with the restricted stock awards made to other key employees in January 2004.   As a result, the fair value of the RSA was calculated on the measurement date and the corresponding compensation expense was deferred as a component of shareholders’ equity and is being expensed over the vesting period of the award, subject to acceleration if specified earnings thresholds are achieved. The CEO RSA was valued at $2.16 per share, which was the closing market price of the Company’s common stock on the measurement date and resulted in a $0.5 million increase to deferred compensation in the Company’s balance sheet. The cost of the common stock shares issued from treasury stock was $3.9 million and the difference between the cost of the treasury stock and fair value of the award, which totaled $3.4 million, was recorded as a reduction of additional paid-in capital. In addition, the CEO received a cash bonus for a portion of the income tax consequences of the RSA. The cash bonus totaled $0.2 million and was expensed as a component of selling, general, and administrative expense when the RSA was granted.

·  
Acceleration of Stock Option Vesting Period - The modification of the CEO options for accelerated vesting was accounted for using guidance found in FASB Interpretation (FIN) No. 44, Accounting for Certain Transactions Involving Stock Compensation. According to FIN 44, the vesting acceleration created a new measurement date. At the new measurement date, the fair value of the Company’s stock was significantly less than the $14 per share exercise price of the CEO stock options and the resulting intrinsic value at the new measurement date for these options is zero. The previous intrinsic value of these options when granted was also zero.                                      

The restricted stock awards previously granted to key employees in January 2004 and to the CEO in December 2004 contain accelerated vesting provisions if the Company achieves specified earnings thresholds. During the quarter ended February 26, 2005, the Company determined that it was probable that the Company would achieve the specified earnings thresholds required to accelerate RSA vesting during the quarter ending May 28, 2005. Accordingly, during the quarter ended February 26, 2005, the Company expensed an additional $0.3 million of deferred compensation for the expected accelerated vesting of the restricted stock awards.

NOTE 3 - CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

The Company considers highly liquid investments with insignificant interest rate risk and original maturities to the Company of three months or less to be cash equivalents. Cash and cash equivalents primarily consist of interest-bearing bank accounts, money market funds, and short-term certificates of deposit.

The Company considers highly liquid investments with an effective maturity to the Company of more than three months and less than one year to be short-term investments. The Company defines effective maturity as the shorter of the original maturity to the Company or the effective maturity as a result of periodic auction of its investments classified as available for sale. Management determines the appropriate classification of investments at the time of purchase and reevaluates such designation as of each balance sheet date. All of the Company’s short-term investments, which totaled $12.4 million and $10.7 million at February 26, 2005 and August 31, 2004, respectively, were classified as available-for-sale securities and were recorded at fair value, which approximated cost.

Realized gains and losses on the sale of these available for sale short-term investments were insignificant for the periods presented. Unrealized gains and losses on the sale of these investments were also insignificant for the periods presented and accordingly were not recorded as a component of other comprehensive income. The Company uses the specific identification method to compute the gains and losses on its short-term investments.

 
 
NOTE 4 - INVENTORIES

Inventories are stated at the lower of cost or market, cost being determined using the first-in, first-out method, and were comprised of the following (in thousands):

   
February 26,
2005
 
August 31,
2004
 
           
Finished goods
 
$
19,808
 
$
19,756
 
Work in process
   
1,184
   
978
 
Raw materials
   
2,431
   
2,959
 
               
   
$
23,423
 
$
23,693
 


NOTE 5 - INTANGIBLE ASSETS

The Company’s intangible assets were comprised of the following (in thousands):
 
 
 
February 26, 2005
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
 
Definite-lived intangible assets:
                   
License rights
 
$
27,000
 
$
(6,011
)
$
20,989
 
Curriculum
   
58,225
   
(24,107
)
 
34,118
 
Customer lists
   
18,774
   
(11,455
)
 
7,319
 
Trade names
   
1,277
   
(1,277
)
 
-
 
     
105,276
   
(42,850
)
 
62,426
 
                     
Indefinite-lived intangible asset:
                   
Covey trade name
   
23,000
   
-
   
23,000
 
Balance at February 26, 2005
 
$
128,276
 
$
(42,850
)
$
85,426
 
                     
August 31, 2004
                   
Definite-lived intangible assets:
                   
License rights
 
$
27,000
 
$
(5,543
)
$
21,457
 
Curriculum
   
58,221
   
(23,067
)
 
35,154
 
Customer lists
   
18,774
   
(10,878
)
 
7,896
 
Trade names
   
1,277
   
(1,277
)
 
-
 
     
105,272
   
(40,765
)
 
64,507
 
                     
Indefinite-lived intangible asset:
                   
Covey trade name
   
23,000
   
-
   
23,000
 
Balance at August 31, 2004
 
$
128,272
 
$
(40,765
)
$
87,507
 
 

The range of remaining estimated useful lives and weighted-average amortization period over which the Company is amortizing its major categories of definite-lived intangible assets at August 31, 2004 were as follows:
 
Category of Intangible Asset
 
Range of Remaining Estimated Useful Lives
 
Weighted Average Amortization Period
         
License rights
 
22 years
 
30 years
Curriculum
 
2 to 22 years
 
26 years
Customer lists
 
1 to 12 years
 
17 years


The Company’s aggregate amortization expense totaled $1.0 million for each of the quarters ended February 26, 2005 and February 28, 2004. Total amortization expense was $2.1 million for each of the two quarters ended February 26, 2005 and February 28, 2004.

 

NOTE 6 - SALE OF CORPORATE HEADQUARTERS FACILITY

During the quarter ended February 26, 2005, the Company entered into a preliminary agreement to sell and leaseback its corporate headquarters facility, located in Salt Lake City, Utah. In connection with the transaction, the Company will enter into a 20-year master lease agreement with the purchaser, a non-related private investment group. The Company will have six five-year options to renew the master lease agreement and could therefore maintain its operations at the current location for the next 50 years. The Company currently expects that its net proceeds from the sale, after transaction costs, will be approximately $32 million. A corresponding financing obligation will be recognized in the Company’s consolidated financial statements for the sale price of the headquarters facility. The completion of the sale is subject to customary conditions, including a due diligence review, survey, and other related closing conditions. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the corporate headquarters facility will continue to be classified as held for use since the Company intends to lease the buildings following the sale.


NOTE 7 - RESTRUCTURING AND STORE CLOSURE COSTS

Restructuring Costs

During fiscal 1999, the Company’s Board of Directors approved a plan to restructure the Company’s operations, reduce its workforce, and formally exit the Company’s leased office space located in Provo, Utah. The Company recorded a $16.3 million restructuring charge during fiscal 1999 to record the expected costs of these activities. Included in the restructuring charge were costs to provide severance and related benefits, as well as expected costs to formally exit the leased office space. This restructuring plan was substantially completed during fiscal 2000.

The Company, under a long-term agreement, leased the Provo office space in buildings that were owned by partnerships, the majority interest of which were owned by a Vice-Chairman of the Board of Directors and certain other employees and former employees of the Company. During the quarter ended November 27, 2004, the Company exercised an option, available under its master lease agreement, to purchase, and simultaneously sell, the office facility to the current tenant, an unrelated party. Based on the continuing negative cash flow associated with these buildings, and other factors, the Company determined that it was in its best interest to exercise the option and sell the property. The negotiated purchase price with the landlord was $14.0 million and the tenant agreed to purchase the property for $12.5 million. These prices were within the range of estimated fair values of the buildings as determined by an independent appraisal obtained by the Company. The Company paid the difference between the sale and purchase prices, plus other closing costs, which were included as a component of the restructuring plan accrual. After accounting for the sale transaction, the remaining fiscal 1999 restructuring costs, which totaled $0.3 million, were credited to operating expenses under the caption, “Restructuring Cost Reversal” in the Company’s condensed consolidated statement of operations for the two quarters ended February 26, 2005.

Store Closure Costs

During fiscal 2004 and the second quarter of fiscal 2005, the Company closed certain retail store locations. The Company closed 14 stores during the quarter ended February 26, 2005 and closed 7 stores subsequent to February 26, 2005. The Company may close other store locations if further analysis indicates that the Company’s operating results may be improved through additional closures. The Company has incurred severance and lease termination costs related to these store closure activities, which are included as a component of selling, general, and administrative expenses in the Company’s consolidated statements of operations.
 
 
The components of the restructuring and store closure accrual were as follows for the periods indicated (in thousands):
 
   
 
Severance Costs
 
Leased Space
Exit Costs
 
 
Total
 
Balance at August 31, 2004
 
$
16
 
$
2,766
 
$
2,782
 
Charges to the accrual
   
178
   
67
   
245
 
Amounts utilized
   
(16
)
 
(2,207
)
 
(2,223
)
Balance at November 27, 2004
   
178
   
626
   
804
 
Charges to the accrual
   
79
   
169
   
248
 
Amounts utilized
   
(23
)
 
(102
)
 
(125
)
Balance at February 26, 2005
 
$
234
 
$
693
 
$
927
 

 
At February 26, 2005, accrued store closure costs were recorded as accrued liabilities in the Company’s condensed consolidated balance sheet. During the two quarters ended February 26, 2005 the Company accrued and expensed $0.2 million of additional leased space exit costs related to changes in estimated sublease receipts on 3 retail store closures that occurred during prior fiscal years. Although the Company believes that its accruals for retail store closures are adequate at February 26, 2005, these amounts are partially based upon estimates and may change if actual amounts related to these activities differ.


NOTE 8 - PREFERRED STOCK RECAPITALIZATION

On March 12, 2005, at the Annual Meeting of Shareholders, the Company’s shareholders approved a plan to recapitalize the Company’s preferred stock. Under terms of the recapitalization plan, the Company completed a one-to-four forward split of the existing Series A preferred stock and then bifurcated each share of Series A preferred stock into a new share of Series A preferred stock that is no longer convertible into common stock, and a warrant to purchase shares of common stock. The new Series A preferred stock retains its common-equivalent voting rights and will automatically convert to shares of Series B preferred stock if the holder of the original Series A preferred stock sells, or transfers, the preferred stock to another party. Series B preferred stock does not have common-equivalent voting rights, but retains substantially all other characteristics of the new Series A preferred stock. The recapitalization transaction will enable the Company to:

·  
Have the conditional right to redeem shares of preferred stock;

·  
Place a limit on the period in which the Company may be required to issue common stock. The new warrants to purchase shares of common stock expire in eight years, compared to the perpetual right of previously existing Series A preferred stock to convert to shares of common stock;

·  
Increase the Company’s ability to purchase shares of its common stock. All purchases of common stock were previously subject to the approval of Series A preferred shareholders;

·  
Create the possibility that the Company may receive cash upon issuing additional shares of common stock to Series A preferred shareholders. The warrants have an exercise price of $8.00 per share compared to the existing right of Series A preferred shareholders to convert their preferred shares into common shares without paying cash; and

·  
Eliminate the requirement to pay common stock dividends to preferred shareholders on an “as converted” basis.
 
 
Each existing Series A preferred shareholder will receive a warrant to purchase a number of common shares equal to 71.43 shares for each $1,000 ($14 per share) in aggregate liquidation value of Series A preferred shares held immediately prior to the recapitalization transaction. The exercise price of each warrant will be $8.00 per share (subject to customary anti-dilution and exercise features) and will be exercisable over an eight-year term.

Upon completion of the recapitalization transaction, Series A preferred rights were amended to prevent the conversion of Series A preferred stock to shares of common stock. Series B preferred stock rights were amended to be substantially equivalent to Series A rights, except for the eliminated voting rights. The rights of the new Series A and Series B preferred stock include the following:

·  
Liquidation Preference - Both Series A and Series B preferred stock have a liquidation preference of $25 per share plus accrued unpaid dividends, which will be paid in preference to the liquidation rights of all other equity classes.

·  
Conversion - Neither Series A nor Series B preferred stock is convertible to shares of common stock. Series A preferred stock converts into shares of Series B upon the sale or transfer of the Series A shares. Series B preferred stock does not have any conversion rights.

·  
Dividends - Both Series A and Series B preferred stock accrue dividends at 10.0 percent, payable quarterly, in preference to dividends on all other equity classes. If dividends are in arrears for six or more quarters, the number of the Company’s Board of Directors will be increased by two and the Series A and Series B preferred shareholders will have the ability to select these additional directors.

·  
Redemption - The Company may redeem any of the Series A or Series B preferred shares during the first year following the recapitalization at a price per share equal to 100 percent of the liquidation preference. Subsequent to the first anniversary of the recapitalization and before the fifth anniversary of the transaction, the Company may only purchase preferred shares (up to $30 million in aggregate) from Knowledge Capital, which holds the majority of the Company’s preferred stock, at a premium that increases one percentage point annually. After the sixth anniversary of the recapitalization, the Company may redeem any shares of preferred stock at 101 percent of the liquidation preference on the date of redemption.

·  
Change in Control - In the event of any change in control of the Company, Knowledge Capital, to the extent that it still holds shares of Series A preferred stock, will have the option to receive a cash payment equal to 101 percent of the liquidation preference of its Series A preferred shares then held. The remaining Series A and Series B preferred shareholders have no such option.

·  
Voting Rights - Although the new Series A preferred shareholders will not have conversion rights, they will still be entitled to voting rights. The holder of each new share of Series A preferred stock will be entitled to the voting rights they would have if they held two shares of common stock. The cumulative number of votes will be based upon the number of votes attributable to shares of Series A held immediately prior to the recapitalization transaction less any transfers of Series A shares to Series B shares or redemptions. In the event that a Series A preferred shareholder exercises a warrant to purchase the Company’s common stock, their Series A voting rights will be reduced by the number of the common shares issued upon exercise of the warrant. This feature will prevent the holders of Series A preferred stock from increasing their voting influence through the acquisition of additional shares of common stock from the exercise of the warrants.

·  
Registration Rights - The Company is required to use its best efforts to register the resale of all shares of common stock and shares of Series B preferred stock issuable upon the transfer and conversion of the Series A preferred stock held by Knowledge Capital and certain permitted transferees of Knowledge Capital within 240 days following the initial filing of the registration statement covering such shares. The initial filing of the registration statement is required to occur within 120 days following the closing of the recapitalization transaction. Any failure by the Company to cause such registration statement to be declared effective within the specified time period would require the Company to pay to Knowledge Capital and such permitted transferees a penalty amount for each share equal to two percent per annum of the $25 face value of the preferred stock calculated based upon the number of days that such registration statement has not been declared effective. Additionally, the Company would have the obligation to use its best efforts to register the resale of the shares of common stock Knowledge Capital and certain permitted transferees could receive pursuant to the exercise of the Warrant issuable to Knowledge Capital at the closing of the recapitalization transaction, provided the obligation to register the resale of such shares would be conditioned upon the weighted average sales price of the common stock over the previous ten trading days being at least 80 percent of the Warrant exercise price. The Company is currently in the process of filing the initial registration statement.
 
 
In order to account for the various aspects of the recapitalization transaction, the Company considered guidance found in SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liability and Equity, Emerging Issues Task Force (EITF) Issue 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, and EITF Issue D-98 Classification and Measurement of Redeemable Securities. Based upon the relevant guidance found in these pronouncements, the Company will account for the various aspects of the preferred stock recapitalization as follows:

New Series A and Series B Preferred Stock - The new shares of preferred stock will continue to be classified as a component of shareholders’ equity since its conversion into cash or common stock is solely within the control of the Company as there are no provisions in the recapitalization documents that would obligate the Company to redeem shares of the Series A or Series B preferred stock. In addition, by virtue of the Utah Control Shares Act, the Company’s Bylaws, and the special voting rights of the preferred shareholders, there are no circumstances under which a third party could acquire controlling voting power of the Company’s stock without consent of the Company’s Board of Directors and thus trigger the Company’s obligation to redeem the new preferred stock. Due to the significant modifications to existing shares of Series A and Series B preferred stock, the Company believes that previously outstanding preferred stock is being replaced with new classes of preferred stock and common stock warrants. As a result, the new preferred stock will be recorded at its fair value on the date of modification, as determined by an independent valuation firm. Consistent with other equity instruments, the carrying value of the new preferred stock will not be subsequently adjusted to its fair market value at the end of any reporting period. Based upon the preliminary valuation of the preferred stock, each new share of preferred stock has an estimated fair value of $20.77 per share on the date of the recapitalization.

The difference between the aggregate fair value of the consideration given (the new Series A preferred stock and the common stock warrants) and the carrying value of the previously existing Series A preferred stock, which is estimated to be a gain of $7.7 million, will be reported as a negative preferred stock dividend, which will increase net income available to common shareholders in the quarter ending May 28, 2005.

Warrants - - EITF Issue 00-19 states that warrants should be classified as a component of shareholders’ equity if 1) the warrant contract requires physical settlement or net-share settlement or 2) the warrant contract gives the Company a choice of net-cash settlement or settlement in its own shares. The Company believes that the warrants should be accounted for as equity instruments because they meet these requirements.

Accordingly, the Company will record the warrants at their fair value, as determined by an independent valuation firm, on the date of the transaction as a component of shareholders’ equity. Subsequent changes in fair value will not be recorded in the Company’s financial statements as long as the warrants remain classified as shareholders’ equity in accordance with EITF Issue 00-19. Based upon a preliminary independent valuation, the warrants have an estimated fair value of $1.11 per share at the date of the recapitalization transaction. The number of common stock warrants issued totaled 6.2 million.

Derivatives - - The modified preferred stock agreement contains a feature that allows the Company to redeem preferred stock at its liquidation preference in the first year following the recapitalization transaction and at 101 percent of the liquidation preference after the sixth anniversary of recapitalization transaction. In accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, the Company has determined that this feature is clearly and closely related to the host contract. Therefore, this embedded call option will not be accounted for separately from the preferred stock.

A separate agreement exists with Knowledge Capital, the entity that holds the majority of the Series A preferred stock, which contains a call option to redeem $30 million of preferred stock at 100 percent to 103 percent of the liquidation preference as well as a “change in control” put option at 101 percent of the liquidation preference. This agreement is a derivative and meets the criteria found in paragraph 11 of SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, to be separately accounted for as a liability. Therefore, the incremental redemption features (the amounts in excess of the 101 percent call option) will be valued at fair value based upon the likelihood of exercise and the expected incremental amount to be paid upon exercise. This derivative-based liability will require adjustment to fair value at each reporting period and is expected to have an initial value of zero on the date of the recapitalization transaction.
 
 
Based upon the foregoing, the following table presents the shareholders’ equity section of the balance sheet as reported in the Company’s Form 10-Q for the quarter ended February 26, 2005 compared to a pro forma presentation of shareholders’ equity if the recapitalization transaction would have been completed as of February 26, 2005 (in thousands):
 
Description
 
As Reported at February 26, 2005
 
Pro Forma at February 26, 2005
 
           
Preferred stock - Series A; no par value; 4,000 shares authorized, 873 and 3,494 shares issued; liquidation preference totaling $89,530
 
$
87,203
 
$
72,566
 
Preferred stock - Series B; no par value; 4,000 shares authorized, no shares issued
   
-
   
-
 
Common stock - $0.05 par value; 40,000 shares authorized, 27,056 shares issued
   
1,353
   
1,353
 
Additional paid-in capital
   
194,960
   
194,960
 
Common stock warrants
   
-
   
6,925
 
Retained earnings (accumulated deficit)
   
(186
)
 
7,526
 
Deferred compensation on restricted stock grants
   
(814
)
 
(814
)
Accumulated other comprehensive income
   
1,111
   
1,111
 
Treasury stock at cost, 6,615 shares
   
(111,901
)
 
(111,901
)
Total shareholders’ equity
 
$
171,726
 
$
171,726
 
 
The accompanying pro forma information has been prepared for comparative purposes only and may not be indicative of the actual impact of the recapitalization transaction when finalized amounts are recorded. In addition, the pro forma information does not give effect to any other transactions that have or may occur subsequent to February 26, 2005.
 
NOTE 9 - INCOME TAXES

The Company recorded income tax expense during the quarters ended February 26, 2005 and February 28, 2004 that totaled $1.0 million and $0.8 million, respectively, and recognized income tax expense for each of the two quarters then ended totaling $1.8 million. The Company’s income tax expense during these periods was primarily due to taxable income in certain foreign tax jurisdictions. The Company was unable to offset the tax liabilities in these jurisdictions with its domestic operating loss. In addition, a history of significant operating losses has precluded the Company from demonstrating that it is more likely than not that the benefits of domestic operating loss carryforwards, together with the benefits of deferred income tax assets, and deferred income tax deductions, will be realized. Accordingly, the Company has recorded valuation allowances on its domestic deferred income tax assets.
 
 
NOTE 10 - COMPREHENSIVE INCOME

Comprehensive income includes charges and credits to equity accounts that are not the result of transactions with shareholders and is comprised of net income or loss and other comprehensive income and loss items. Comprehensive income for the Company was as follows (in thousands):
 
   
Quarter Ended
 
Two Quarters Ended
 
   
February 26,
2005
 
February 28,
2004
 
February 26,
2005
 
February 28,
2004
 
Net income (loss)
 
$
7,086
 
$
232
 
$
8,612
 
$
(2,948
)
Other comprehensive income (loss) items:
                         
Adjustment for fair value of hedge derivatives
   
(26
)
 
-
   
(318
)
 
-
 
Foreign currency translation adjustments
   
(232
)
 
69
   
403
   
791
 
Comprehensive income (loss)
 
$
6,828
 
$
301
 
$
8,697
 
$
(2,157
)


NOTE 11 - EARNINGS PER SHARE

Basic earnings per common share (EPS) is calculated by dividing net income or loss available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS is calculated by dividing net income or loss available to common shareholders, by the weighted-average number of common shares outstanding plus the assumed exercise of all dilutive securities using the treasury stock method or the “as converted” method, as appropriate. The Company’s Series A preferred shareholders (prior to recapitalization) were entitled to participate in dividends payable to holders of common stock pro rata based upon the number of shares of common stock into which the Series A preferred stock is convertible. Accordingly, the Company uses the two class method as defined in SFAS No. 128, Earnings Per Share, and EITF Issue 03-6, Participating Securities and the Two-Class Method under FASB Statement No. 128 to calculate basic EPS. The two class method assumes that 100 percent of the Company’s earnings are distributed as dividends to each participating equity class based upon their respective ability to participate in such declared dividends. The following table presents the computation of the Company’s EPS for the periods indicated (in thousands, except per share amounts):
   
Quarter Ended
 
Two Quarters Ended
 
   
February 26,
2005
 
February 28,
2004
 
February 26,
2005
 
February 28,
2004
 
Net income (loss)
 
$
7,086
 
$
232
 
$
8,612
 
$
(2,948
)
Convertible preferred stock dividends
   
(2,184
)
 
(2,184
)
 
(4,368
)
 
(4,368
)
Net income (loss) after preferred stock dividends
 
$
4,902
 
$
(1,952
)
$
4,244
 
$
(7,316
)
                           
Convertible preferred stock dividends
 
$
2,184
 
$
2,184
 
$
4,368
 
$
4,368
 
Weighted average preferred shares on an as converted basis
   
6,239
   
6,239
   
6,239
   
6,239
 
Distributed EPS - preferred
 
$
.35
 
$
.35
 
$
.70
 
$
.70
 
                           
Undistributed income (loss)
 
$
4,902
 
$
(1,952
)
$
4,244
 
$
(7,316
)
Preferred ownership on an as converted basis
   
24
%
 
24
%
 
24
%
 
24
%
Preferred shareholders interest in undistributed income (loss) (1)
   
1,176
   
-
   
1,019
   
-
 
Weighted average preferred shares on an as converted basis
   
6,239
   
6,239
   
6,239
   
6,239
 
Undistributed EPS - preferred
 
$
.19
 
$
-
 
$
.16
 
$
-
 
                           
Undistributed income (loss)
 
$
4,902
 
$
(1,952
)
$
4,244
 
$
(7,316
)
Common stock ownership
   
76
%
 
76
%
 
76
%
 
76
%
Common shareholder interest in undistributed income (loss) (1)
 
$
3,726
 
$
(1,952
)
$
3,225
 
$
(7,316
)
                           
Weighted average common shares outstanding - Basic
   
19,880
   
19,940
   
19,790
   
19,953
 
Common share equivalents (2)
   
60
   
-
   
14
   
-
 
Weighted average common shares outstanding - Diluted
   
19,940
   
19,940
   
19,804
   
19,953
 
                           
Basic EPS - Common
 
$
.19
 
$
(.10
)
$
.16
 
$
(.37
)
Diluted EPS - Common
 
$
.19
 
$
(.10
)
$
.16
 
$
(.37
)

(1) Preferred shareholders do not participate in any undistributed losses with common shareholders, therefore no adjustment to the fiscal 2004 loss per share information was made.
(2) For the three months and six months ended February 28, 2004, conversion of common share equivalents is not assumed because such conversion would be anti-dilutive.

At February 26, 2005 the Company had approximately 2.3 million stock options outstanding which were not included in the computation of diluted EPS because the options’ exercise price was greater than the average market price of the Company’s common shares.
 
Subsequent to February 26, 2005, the Company’s shareholders approved the recapitalization of the Company’s preferred stock (Note 8). In connection with the recapitalization, the Series A preferred stock is no longer convertible into shares of common stock and the existing preferred shareholders were issued 6.2 million warrants (the equivalent number of common shares that could have been issued to Series A preferred shareholders on an “as converted” basis) to purchase common stock with an exercise price of $8.00 per share. These warrants, which expire in eight years, may have a dilutive impact on the Company’s EPS in future periods.
 
 
NOTE 12 - ACCOUNTING FOR DERIVATIVE INSTRUMENTS

During the normal course of business, the Company is exposed to fluctuations in foreign currency exchange rates due to its international operations and fluctuations in interest rates. To manage risks associated with foreign currency exchange and interest rates, the Company makes limited use of derivative financial instruments. Derivatives are financial instruments that derive their value from one or more underlying financial instruments. As a matter of policy, the Company’s derivative instruments are entered into for periods that do not exceed the related underlying exposures and do not constitute positions that are independent of those exposures. In addition, the Company does not enter into derivative contracts for trading or speculative purposes, nor is the Company party to any leveraged derivative instrument. The notional amounts of derivatives do not represent actual amounts exchanged by the parties to the instrument and thus, are not a measure of exposure to the Company through its use of derivatives. The Company enters into derivative agreements only with highly rated counterparties.

Foreign Currency Exposure

Due to the global nature of the Company’s operations, the Company is subject to risks associated with transactions that are denominated in currencies other than the United States dollar, as well as the effects of translating amounts denominated in foreign currencies to United States dollars as a normal part of the reporting process. The objective of the Company’s foreign currency risk management activities is to reduce foreign currency risk in the consolidated financial statements. In order to manage foreign currency risks, the Company makes limited use of foreign currency forward contracts and other foreign currency related derivative instruments. Although the Company cannot eliminate all aspects of its foreign currency risk, the Company believes that its strategy, which includes the use of derivative instruments, can reduce the impacts of foreign currency related issues on its consolidated financial statements.

During the quarter and two quarters ended February 26, 2005, the Company utilized foreign currency forward contracts to manage the volatility of certain intercompany financing transactions and other transactions that are denominated in foreign currencies. Because these contracts do not meet specific hedge accounting requirements, gains and losses on these contracts, which expire on a quarterly basis, are recognized currently and are used to offset a portion of the gains or losses of the related accounts. The gains and losses on these contracts were recorded as a component of selling, general, and administrative expense in the Company’s consolidated statements of operations and resulted in the following net gains or losses for the periods indicated (in thousands):

   
Quarter Ended
 
Two Quarters Ended
 
   
February 26,
2005
 
February 28,
2004
 
February 26,
2005
 
February 28,
2004
 
Losses on foreign exchange contracts
 
$
(58
)
$
(148
)
$
(353
)
$
(539
)
Gains on foreign exchange contracts
   
3
   
-
   
3
   
24
 
Net loss on foreign exchange contracts
 
$
(55
)
$
(148
)
$
(350
)
$
(515
)
 
At February 26, 2005, the fair value of these contracts, which was determined using the estimated amount at which contracts could be settled based upon forward market exchange rates, was insignificant. The notional amounts of the Company’s foreign currency sell contracts that did not qualify for hedge accounting were as follows at February 26, 2005 (in thousands):
 
Contract Description
 
Notional Amount in Foreign Currency
 
Notional Amount in U.S. Dollars
 
           
Australian Dollars
   
1,760
 
$
1,366
 
Mexican Pesos
   
9,200
   
812
 
Japanese Yen
   
40,000
   
391
 
 
 
During the quarter and two quarters ended February 26, 2005, the Company also entered into foreign currency forward contracts that were designed to manage foreign currency risks related to the value of the Company’s net investment in its directly-owned operations located in Canada, Japan, and the United Kingdom. These three offices comprise the majority of the Company’s net investment in foreign operations. These foreign currency forward instruments, which expire on a monthly basis, qualified for hedge accounting and corresponding gains and losses were recorded as a component of other comprehensive income in the Company’s consolidated balance sheet. The gains and losses on these contracts were as follows for the periods presented (in thousands):

   
Quarter Ended
 
Two Quarters Ended
 
   
February 26,
2005
 
February 28,
2004
 
February 26,
2005
 
February 28,
2004
 
Losses on net investment hedge contracts
 
$
(72
)
$
-
 
$
(384
)
$
-
 
Gains on net investment hedge contracts
   
46
   
-
   
66
   
-
 
Net loss on net investment hedge contracts
 
$
(26
)
$
-
 
$
(318
)
$
-
 
 
As of February 26, 2005, the Company had settled its net investment hedge contracts. However, the Company may utilize net investment hedge contracts in future periods as a component of its overall foreign currency risk strategy.

Interest Rate Exposure

Due to the limited nature of its interest rate risk, the Company does not make regular use of interest rate derivatives and the Company was not a party to any interest rate derivative instruments during the quarter or two quarters ended February 26, 2005 or February 28, 2004.
 
NOTE 13 - SEGMENT INFORMATION

The Company has two reporting segments: the Consumer and Small Business Unit (CSBU) and the Organizational Solutions Business Unit (OSBU). The following is a description of the Company’s reporting segments, their primary operating components, and their significant business activities:

Consumer and Small Business Unit - This business unit is primarily focused on sales to individual customers and includes the results of the Company’s domestic retail stores, consumer direct operations (catalog and eCommerce), wholesale operations and other related distribution channels, including government product sales and external publishing sales. The CSBU results of operations also include the financial results of the Company’s paper planner manufacturing operations. Although CSBU sales primarily consist of products such as planners, binders, software, and handheld electronic planning devices, virtually any component of the Company’s leadership, productivity, and strategy execution solutions may be purchased through CSBU channels.

Organizational Solutions Business Unit - The OSBU is primarily responsible for the development, marketing, sale, and delivery of productivity, leadership, strategy execution, sales force performance, and communication training and consulting solutions directly to organizational clients, including other companies, the government, and educational institutions. The OSBU includes the financial results of the Organizational Solutions Group (OSG) and international operations. The OSG is responsible for the domestic sale and delivery of the Company’s training and consulting services. The Company’s international sales group includes the financial results of its directly owned foreign offices and royalty revenues from licensees.

 
The Company’s chief operating decision maker is the CEO, and each of the reportable segments has a president who reports directly to the CEO. The primary measurement tool used in business unit performance analysis is earnings before interest, taxes, depreciation, and amortization (EBITDA), which may not be calculated as similarly titled amounts are calculated by other companies. For segment reporting purposes, the Company’s consolidated EBITDA can be calculated as its income or loss from operations excluding depreciation and amortization charges.

In the normal course of business, the Company may make structural and cost allocation revisions to its segment information to reflect new reporting responsibilities within the organization. All prior period segment information has been revised to conform to the most recent classifications and organizational changes. The Company accounts for its segment information on the same basis as the accompanying condensed consolidated financial statements.
 
 
SEGMENT INFORMATION
(in thousands)
 
 
 
 
Consumer and Small Business Unit
 
Organizational Solutions Business Unit
         
 
Quarter Ended February 26, 2005
 
 
 
Retail
 
 
Consumer Direct
 
 
 
Wholesale
 
 
Other CSBU
 
 
 
OSG
 
 
 
International
 
 
Corporate and Eliminations
 
 
 
Consolidated
 
Sales to external customers
 
$
28,055
 
$
16,765
 
$
4,897
 
$
765
 
$
17,784
 
$
14,257
       
$
82,523
 
Gross margin
   
16,599
   
9,698
   
2,318
   
(1,045
)
 
12,556
   
9,939
         
50,065
 
EBITDA
   
6,183
   
7,471
   
2,157
   
(6,264
)
 
2,435
   
3,559
   
(4,263
)
 
11,278
 
Depreciation
   
844
   
247
         
172
   
78
   
337
   
642
   
2,320
 
Amortization
                     
86
   
954
   
2
   
1
   
1,043
 
                                                   
Quarter Ended February 28, 2004
                                                 
Sales to external customers
   
32,668
   
16,265
   
3,663
   
634
   
13,110
   
12,375
         
78,715
 
Gross margin
   
18,314
   
9,182
   
1,405
   
(1,137
)
 
8,374
   
8,487
         
44,625
 
EBITDA
   
5,764
   
5,757
   
1,120
   
(5,995
)
 
(1,692
)
 
2,791
   
(2,530
)
 
5,215
 
Depreciation
   
818
   
259
         
313
   
179
   
325
   
1,328
   
3,222
 
Amortization
                     
86
   
954
   
2
   
1
   
1,043
 
                                                   
Two Quarters Ended February 26, 2005
                                                 
Sales to external customers
   
46,443
   
33,901
   
8,480
   
1,750
   
32,912
   
28,141
         
151,627
 
Gross margin
   
26,977
   
19,852
   
4,077
   
(1,676
)
 
22,576
   
19,418
         
91,224
 
EBITDA
   
6,536
   
15,422
   
3,702
   
(12,590
)
 
3,044
   
7,158
   
(6,488
)
 
16,784
 
Depreciation
   
1,522
   
493
         
349
   
154
   
663
   
1,317
   
4,498
 
Amortization
                     
172
   
1,907
   
4
   
4
   
2,087
 
                                                   
Two Quarters Ended February 28, 2004
                                                 
Sales to external customers
   
55,336
   
34,477
   
10,126
   
1,222
   
27,058
   
25,527
         
153,746
 
Gross margin
   
30,297
   
19,832
   
4,468
   
(2,228
)
 
17,188
   
17,594
         
87,151
 
EBITDA
   
5,209
   
13,160
   
3,886
   
(12,771
)
 
(3,037
)
 
6,036
   
(4,758
)
 
7,725
 
Depreciation
   
1,788
   
568
         
692
   
431
   
632
   
2,702
   
6,813
 
Amortization
                     
172
   
1,908
   
4
   
3
   
2,087
 


A reconciliation of reportable segment EBITDA to consolidated loss before income taxes is provided below (in thousands):

   
Quarter Ended
 
Two Quarters Ended
 
   
February 26,
2005
 
February 28,
2004
 
February 26,
2005
 
February 28,
2004
 
Reportable segment EBITDA
 
$
15,541
 
$
7,745
 
$
23,272
 
$
12,483
 
Restructuring cost reversal
               
306
       
Corporate expenses
   
(4,263
)
 
(2,530
)
 
(6,794
)
 
(4,758
)
Consolidated EBITDA
   
11,278
   
5,215
   
16,784
   
7,725
 
Depreciation
   
(2,320
)
 
(3,222
)
 
(4,498
)
 
(6,813
)
Amortization
   
(1,043
)
 
(1,043
)
 
(2,087
)
 
(2,087
)
Income (loss) from operations
   
7,915
   
950
   
10,199
   
(1,175
)
Interest income
   
165
   
141
   
282
   
227
 
Interest expense
   
(29
)
 
(56
)
 
(66
)
 
(167
)
Income (loss) before provision for income taxes
 
$
8,051
 
$
1,035
 
$
10,415
 
$
(1,115
)


NOTE 14 - CEO COMPENSATION AGREEMENT

During November 2004, the Company’s Board of Directors approved a proposal to change a number of items with regard to the Company’s CEO employment agreement. The changes to the CEO’s employment agreement were completed during December 2004 and the corresponding costs related to the new agreement were recorded in the quarter ended February 26, 2005. Refer to Note 2 - “Accounting For Stock-Based Compensation” for a detailed discussion regarding the financial statement impacts of the changes to the CEO’s employment agreement. At the request of the CEO, the changes to his employment agreement included the following:

·  
The previously existing CEO employment agreement, which extended until 2007, was canceled and the CEO became an “at-will” employee.

·  
The CEO signed a waiver forgoing claims on past compensation not taken.

·  
The CEO agreed to be covered by change in control and severance policies provided for other Company executives rather than the “golden parachute” severance package in his previously existing agreement.

·  
In accordance with the provisions of the Sarbanes-Oxley Act of 2002, the CEO will not be entitled to obtain a loan in order to exercise his stock options.

In return for these changes to the CEO’s compensation structure and in recognition of the CEO’s leadership in achieving substantial improvements in the Company’s operating results, the Company agreed to the following:

·  
The CEO’s cash compensation, both base compensation and incentive compensation, will remain essentially unchanged.

·  
The vesting period on the CEO’s 1.6 million stock options with an exercise price of $14.00 per share was accelerated and all of these options are now fully vested.

·  
A grant of 225,000 shares of restricted stock as a long-term incentive consistent with the restricted stock awards made to other key employees in January 2004. In addition, the Company granted the CEO 187,000 shares of common stock that is fully vested. The compensation cost of both of these awards is $0.9 million, of which $0.5 million was initially recorded as deferred compensation in shareholders’ equity and amortized over five years, subject to accelerated vesting if certain performance thresholds are met (Note 2).

·  
The Company will also provide life insurance and disability coverage in an amount equal to 2.5 times the CEO’s cash compensation, using insurance policies that are similar to those approved for other executives. The cost of this life insurance policy on the CEO is expected to be insignificant.


NOTE 15 - SUBSEQUENT EVENT

Val J. Christensen, Executive Vice-President, General Counsel and Secretary of the Company, terminated his service as an executive officer and employee of the Company, on March 29, 2005. Under the terms of the corresponding Separation Agreement, the Company will pay to Mr. Christensen a lump-sum severance amount totaling $0.9 million, less applicable withholdings.  In addition, he will receive the cash performance bonus he would have been entitled to for the current fiscal year as if he had remained employed in his prior position and his performance objectives for the year were met, which is estimated to be $0.15 million. In addition to these payments, his shares of restricted stock were fully vested and he will be entitled to receive a bonus totaling $57,000, which is calculated equivalent to other bonuses awarded in the January 2004 RSA (Note 2), to offset a portion of the income taxes resulting from the vesting of his restricted stock award. The Company also waived the requirement that his fully-vested stock options be exercised within 90 days of his termination and allows the options to be exercised through the term of the option agreement.
 
Subsequent to entering into the Separation Agreement, the Company and Mr. Christensen entered into a Legal Services Agreement on March 29, 2005. Under terms of the Legal Services Agreement, the Company will retain Mr. Christensen as independent legal counsel to provide services to the Company for a minimum of 1,000 hours per year. The Legal Services Agreement will allow the Company to benefit from Mr. Christensen’s extensive institutional knowledge and experience gained from serving as the Company’s General Counsel as well as his experience representing the Company as external counsel for several years prior to joining the Company, while allowing Mr. Christensen one-half of his time to pursue other interests apart from providing legal services.  The Company will pay Mr. Christensen an annual retainer in the amount of $0.2 million, the equivalent of $225 per hour for each hour of legal services, and $325 per hour for every hour of legal services, if any, provided in excess of 1,000 hours in any given year. Further, Mr. Christensen will be an independent contractor and not entitled to Company benefits for performing these services.
 
Subsequent to his separation, the Board of Directors approved modifications to his management stock loan substantially similar to the modifications granted to other loan participants by the Board of Directors in May 2004 under which the Company will forego certain of its rights under the terms of the loans in order to potentially improve the participants' ability to pay, and the Comany's ability to collect, the outstanding balances of the loans.



ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


Management’s discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based upon management’s current expectations and are subject to various uncertainties and changes in circumstances. Important factors that could cause actual results to differ materially from those described in forward-looking statements are set forth below under the heading Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995.

The Company suggests that the following discussion and analysis be read in conjunction with the Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended August 31, 2004.


RESULTS OF OPERATIONS

Overview

Our second fiscal quarter, which includes the months of December, January, and February, historically represents our seasonally busiest months as many of our clients renew their planners on a calendar basis and purchase gifts, including binders, leather totes, and planning tools for the holidays. As a result, this quarter generally has better operating results than other quarters of our fiscal year. Our financial results for the quarter and two quarters ended February 26, 2005 represented significant improvements over the comparable periods of the prior year and continued the favorable momentum that began in prior periods. For the quarter ended February 26, 2005, our income from operations improved to $7.9 million, compared to $1.0 million in the prior year. Our operating income for the two quarters ended February 26, 2005 likewise improved to $10.2 million compared to a loss of $1.2 million in the prior year. Our net income available to common shareholders for the quarter ended February 26, 2005 was $4.9 million compared to a net loss in the prior year of $2.0 million. For the two quarters ended February 26, 2005, our net income available to common shareholders was $4.2 million compared to a net loss of $7.3 million for the corresponding period of fiscal 2004. The primary factors that influenced our operating results for the quarter ended February 26, 2005 were as follows:

·  
Sales Performance - Training and consulting services sales increased $5.6 million compared to the prior year, which was attributable to increased training and consulting sales in both domestic and international delivery channels. In addition, our seminar booking pace in fiscal 2005 continues to exceed prior year levels. We have also recently completed significant enhancements to our The 7 Habits of Highly Effective People training courses and related products, which were released in March 2005. We believe that our increased booking pace and refreshed course materials and related products, in combination with our other training offerings, will be a factor in continuing improvements in our training and consulting sales performance.

Product sales decreased by $1.8 million, which was primarily due to the impact of closed retail stores and declining technology and specialty product sales, which were partially offset by the timing of wholesale product orders and increased “core” product (e.g. binders and planners) sales compared to the prior year.

·  
Gross Margin Improvement - Our gross margin improved compared to the prior year primarily due to increased training and consulting sales as a percent of total sales, favorable product and training program mix changes, reduced product costs, and lower overall costs in delivering our training and consulting service sales.

·  
Decreased Operating Costs - Overall operating costs decreased by $1.5 million, primarily due to reduced depreciation and selling, general, and administrative (SG&A) expenses. Consistent with prior periods, we continue to seek for and implement strategies that will enable the Company to reduce its operating costs in order to improve profitability.

 
Although the Company recognized improved financial results compared to the prior year, management does not believe that current operating performance is entirely satisfactory and is continuing its efforts to increase sales, improve gross margins, and reduce operating costs in order to achieve consistently profitable operations. Further details regarding our operating results and liquidity are provided throughout the following management’s discussion and analysis.

Quarter Ended February 26, 2005 Compared to the Quarter Ended February 28, 2004

Sales

The following table sets forth sales data for our operating segments (in thousands):

   
Quarter Ended
 
Two Quarters Ended
 
   
February 26, 2005
 
February 28, 2004
 
Percent
Change
 
February 26, 2005
 
February 28, 2004
 
Percent
Change
 
Consumer and Small
Business Unit:
                         
Retail Stores
 
$
28,055
 
$
32,668
   
(14)
 
$
46,443
   
55,336
   
(16)
 
Consumer Direct
   
16,765
   
16,265
   
3
   
33,901
   
34,477
   
(2)
 
Wholesale
   
4,897
   
3,663
   
34
   
8,480
   
10,126
   
(16)
 
Other CSBU
   
765
   
634
   
21
   
1,750
   
1,222
   
43
 
     
50,482
   
53,230
   
(5)
 
 
90,574
   
101,161
   
(10)
 
Organizational Solutions
Business Unit:
                                     
Organizational Solutions Group
   
17,784
   
13,110
   
36
   
32,912
   
27,058
   
22
 
International
   
14,257
   
12,375
   
15
   
28,141
   
25,527
   
10
 
     
32,041
   
25,485
   
26
   
61,053
   
52,585
   
16
 
Total Sales
 
$
82,523
 
$
78,715
   
5
 
$
151,627
 
$
153,746
   
(1)
 


Product Sales - Product sales, which primarily consist of planners, binders, software, and handheld electronic planning devices, which are primarily sold through our Consumer and Small Business Unit (CSBU) channels, declined $1.8 million, or three percent, compared to the quarter ended February 28, 2004. The decline in product sales was primarily due to sales performance in our retail store channel, which declined $4.6 million, or 14 percent, compared to the prior year. The following is a description of significant sales fluctuations in our CSBU channels:

·  
Retail Sales - The decline in retail sales was primarily due to the impact of fewer stores, which totaled $3.0 million, and reduced technology and specialty product sales, which totaled $2.2 million. Declining technology and specialty product sales were partially offset by increased “core” product sales. Overall product sales trends were reflected by a five percent decline in comparable store (stores which were open during the comparable periods) sales. During fiscal 2004, we closed 18 retail store locations and we have closed 14 additional stores during the second quarter of fiscal 2005. At February 26, 2005, we were operating 121 retail stores compared to 144 stores at February 28, 2004.

·  
Consumer Direct - Sales through our consumer direct channels (catalog and eCommerce) were generally consistent with the prior year and improved primarily due to increased “core” product sales compared to the prior year.

·  
Wholesale Sales - Sales through our wholesale channel, which includes sales to office superstores and other retail chains, increased primarily due to the timing of product sales to these entities.

 
Training and Consulting Services Sales - We offer a variety of training solutions, training related products, and consulting services focused on productivity, leadership, strategy execution, sales force performance, and effective communications training programs that are provided both domestically and internationally through the Organizational Solutions Business Unit (OSBU). Our overall training and related service sales increased by $5.6 million, or 26 percent, compared to the same period of the prior year. The improvement in training sales was reflected in increased domestic training program sales, which are delivered through our Organizational Sales Group (OSG), as well as through our international operations. OSG sales performance improved in nearly all of our domestic sales regions and was primarily attributable to increased sales of “Helping Clients Succeed,” “The 4 Disciplines of Leadership,” and The 7 Habits of Highly Effective People training courses. We currently expect our domestic training and services sales to continue to strengthen as our seminar booking pace continues to exceed prior year levels. International sales improved primarily due to increased sales in Japan, increased licensee royalty revenues, and the translation of foreign sales amounts as foreign currencies strengthened against the United States dollar. The favorable impact of currency translation on reported international revenues totaled $0.4 million for the quarter ended February 26, 2005.

Gross Margin

Gross margin consists of net sales less the cost of goods sold or services provided. Our overall gross margin for the quarter improved to 60.7 percent of sales, compared to 56.7 percent in the comparable quarter of fiscal 2004. This overall gross margin improvement is consistent with gross margin performance during our first quarter of fiscal 2005 and was primarily due to increased training and consulting sales as a percent of total sales, favorable product mix changes, and improved margins on our training and consulting service sales. Training and consulting service sales, which typically have higher gross margins than our product sales, increased to 33 percent of total sales during the quarter ended February 26, 2005 compared to 28 percent in the prior year. Our gross margin on product sales improved to 55.2 percent compared to 52.8 percent in fiscal 2004 and was primarily due to a favorable shift in our product mix as sales of higher-margin paper products and binders increased as a percent of total sales, while sales of lower-margin technology and specialty products continue to decline. Additionally, the overall margin on paper and binder sales has improved through focused cost reduction efforts and improved inventory management.

Training and related consulting services gross margin, as a percent of sales of these services, improved to 71.8 percent compared to 66.9 percent in the corresponding quarter of fiscal 2004. The improvement in our training and consulting services gross margin was primarily due to a shift in training sales mix toward higher-margin courses, reduced costs for training materials, such as participant manuals and related items, and overall lower costs associated with training sales.

Operating Expenses

Selling, General and Administrative - Our selling, general, and administrative expenses decreased $0.6 million, or two percent, compared to the corresponding quarter of the prior year. Total SG&A expenses as a percent of sales decreased to 47.0 percent compared to 50.0 percent in fiscal 2004. We continue to implement cost-cutting strategies that have been successful in reducing our operating costs, including retail store closures, headcount reductions, consolidation of corporate office space, and other measures designed to focus our resources on critical activities and projects. However, during the quarter ended February 26, 2005 our cost reduction efforts were partially offset by expenses related to changes in the CEO’s compensation, additional costs associated with the preferred stock recapitalization, and increased commission expenses related to increased training sales. We also recognized $0.4 million of expense related to the closure of retail store locations during the quarter. In addition, we will record $1.2 million of expense related to the severance agreement with a former executive officer during the quarter ended May 28, 2005.

We regularly assess the operating performance of our retail stores, including previous operating performance trends and projected future profitability. During this assessment process, judgments are made as to whether under-performing or unprofitable stores should be closed. As a result of this evaluation process, we closed 14 stores during the quarter ended February 26, 2005, have closed 7 more stores subsequent to February 26, 2005, and currently plan to close 8 additional retail locations during the remainder fiscal 2005. The number of retail stores that we plan to close may increase if further analysis indicates that the Company’s operating results may be improved through additional closures, due to the higher costs associated with operating our retail store channel. Retail locations that are currently scheduled to be closed primarily consist of under performing stores or stores in markets where we have multiple retail locations. In addition, nearly all of the planned retail store closures are in locations where the underlying leases expire during fiscal 2005. The costs associated with closing retail stores are typically comprised of charges related to vacating the premises, which may include a provision for the remaining term on the lease, and severance and other personnel costs. These store closure costs totaled $0.4 million in the quarter ended February 26, 2005 and were included as a component of SG&A expenses. Based upon our continuing analyses of retail store performance, we may close additional retail stores and will continue to incur costs associated with closing these stores in future periods.

 
Depreciation and Amortization - Depreciation expense decreased $0.9 million, or 28 percent, compared to the second quarter of fiscal 2004 primarily due to the full depreciation or disposal of certain property and equipment balances and the effects of significantly reduced capital expenditures during preceding fiscal years. Based upon these events and current capital spending trends, we expect that depreciation expense will continue to decline compared to prior periods during the remainder of fiscal 2005.

Amortization expense on definite-lived intangible assets totaled $1.0 million for the quarters ended February 26, 2005 and February 28, 2004. We expect intangible asset amortization expense to total $4.2 million during fiscal 2005.

Income Taxes

The provision for income taxes increased to $1.0 million compared to $0.8 million in the prior year. The increase was primarily due to fluctuations in our income tax expense in foreign tax jurisdictions. As of February 26, 2005, given our history of significant operating losses, we had provided a valuation allowance against substantially all of our domestic deferred income tax assets.
 
Two Quarters Ended February 26, 2005 Compared to the Two Quarters Ended February 28, 2004

Sales

Product sales, which primarily consist of planners, binders, software, and handheld electronic planning devices, which are primarily sold through our CSBU channels, declined $9.6 million, or nine percent, compared to the prior year. The decline in product sales was primarily due to decreased sales in our retail and wholesale delivery channels. The majority of the decline in product sales occurred during our first quarter as overall product sales declined only $1.8 million during our second quarter, when compared to the prior year. The following is a description of sales fluctuations in our CSBU channels for the two quarters ended February 26, 2005:
 
·  
Retail Sales - The decline in retail sales was primarily due to reduced technology and specialty product sales, which totaled $5.4 million, and the impact of fewer stores, which totaled $5.0 million. Declining technology and specialty product sales were partially offset by increased “core” product sales, which totaled $1.0 million. Overall product sales trends were reflected by an eight percent decline in year-to-date comparable store sales.

·  
Consumer Direct - Sales through our consumer direct channels (catalog and eCommerce) were generally consistent with the prior year and the slight decline was primarily due to decreased technology and specialty product sales compared to the prior year.

·  
Wholesale Sales - Sales through our wholesale channel, which includes sales to office superstores and other retail chains, decreased primarily due to the timing of product sales to these entities. In the previous fiscal year, we recognized significant wholesale sales as we opened new wholesale channels and sold product to fill these new venues. We expect wholesale sales will improve during the remainder of fiscal 2005 and that total wholesale sales will be consistent with fiscal 2004 sales performance.

·  
Other CSBU Sales - Other CSBU sales primarily consist of external printing and publishing sales and building lease revenues. We have leased a substantial portion of our corporate campus in Salt Lake City, Utah and have recognized $0.4 million of lease revenue during fiscal 2005, which has been classified as other CSBU sales. During fiscal 2005, we have also made an effort to increase external printing sales in order to increase the utilization of our printing and publishing assets, which has improved printing and publishing sales compared to the prior year.

 
Product sales were also favorably affected by increased international catalog sales and increased retail sales in Japan, which totaled $1.6 million compared to the prior year. Although sales from these channels are recorded in the international segment of OSBU, sales from these OSBU channels are classified as product sales, in our condensed consolidated statements of operations.


We offer a variety of training solutions, training related products, and consulting services focused on productivity, leadership, strategy execution, sales force performance, and effective communications training programs that are provided both domestically and internationally through the OSBU. Our overall training and related consulting services sales increased by $7.4 million, or 17 percent, compared to the same period of fiscal 2004. The improvement in training sales was reflected in increased domestic program sales, which are delivered through the OSG, as well as through our international operations. OSG sales performance has improved in nearly all of our domestic sales regions and in our sales performance group. We currently expect our domestic training and consulting services sales to continue to strengthen in fiscal 2005. International sales improved primarily due to increased sales in Japan and Mexico, increased licensee royalty revenues, and the translation of foreign sales amounts as foreign currencies strengthened against the United States dollar. These increases were partially offset by decreased sales performance in Canada and Brazil.

Gross Margin

Our overall gross margin for the two quarters ended February 26, 2005 improved to 60.2 percent of sales, compared to 56.7 percent in the comparable period of fiscal 2004. The improvement in our overall gross margin was primarily due to increased training and consulting sales as a percent of total sales, favorable product mix changes, and improved margins on our training and consulting service sales. Training and consulting service sales, which typically have higher gross margins than the majority of our product sales, increased to 35 percent of total sales during the two quarters ended February 26, 2005 compared to 29 percent in the prior year. Our gross margin on product sales improved to 54.8 percent compared to 52.6 percent in fiscal 2004 and was primarily due to a favorable shift in our product mix as sales of higher-margin paper products and binders increased as a percent of total sales, while sales of lower-margin technology and specialty products continue to decline. Additionally, the overall margin on paper and binder sales has improved through focused cost reduction efforts, and improved inventory management.

Training and related consulting services gross margin, as a percent of sales of these services, improved to 70.3 percent compared to 66.6 percent in the corresponding period of fiscal 2004. The improvement in our training and services gross margin was primarily due to a shift in training sales mix toward higher-margin 7 Habits courses, reduced costs for training materials, such as participant manuals and related items, and overall lower costs associated with training sales.

Operating Expenses

Selling, General and Administrative - Our SG&A expenses decreased $5.0 million, or six percent, compared to the prior year. Total SG&A expenses as a percent of sales decreased to 49.1 percent compared to 51.7 percent in the first two quarters of fiscal 2004. Declining SG&A expenses were the direct result of initiatives specifically designed to reduce our overall operating costs and is consistent with operating expense trends during the previous two fiscal years. Our cost-reduction efforts have included retail store closures, headcount reductions, consolidation of corporate office space, and other measures designed to focus our resources on critical activities and projects. These efforts were partially offset by SG&A expenses in our quarter ended February 26, 2005 resulting from expenses related to changes in the CEO’s compensation, additional costs associated with the preferred stock recapitalization, and increased commission expenses related to increased training sales. The primary effects of our cost-cutting initiatives were reflected in associate expense reductions totaling $2.2 million, reduced rent and utilities expenses of $1.5 million, reduced computer and office supply charges totaling $0.7 million, and reductions in other SG&A expenses, such as outsourcing and development costs, that totaled $0.3 million compared to the prior year. In addition, we will record $1.2 million of expense related to the severance agreement with a former executive officer during the quarter ended May 28, 2005.
 
We regularly assess the operating performance of our retail stores, including previous operating performance trends and projected future profitability. During this assessment process, judgments are made as to whether under-performing or unprofitable stores should be closed. As a result of this evaluation process, we closed 14 stores during the two quarters ended February 26, 2005, have closed 7 more stores subsequent to February 26, 2005, and currently plan to close 8 additional retail locations during the remainder fiscal 2005. The costs associated with closing retail stores are typically comprised of charges related to vacating the premises, which may include a provision for the remaining term on the lease, and severance and other personnel costs. These store closure costs totaled $0.6 million for the two quarters ended February 26, 2005 and were included as a component of SG&A expenses. Based upon our continuing analyses of retail store performance, we may close additional retail stores and will continue to incur costs associated with closing these stores in future periods.

Restructuring Cost Reversal - During fiscal 1999, our Board of Directors approved a plan to restructure our operations, which included an initiative to formally exit leased office space located in Provo, Utah. We recorded a $16.3 million restructuring charge during fiscal 1999 to record the expected costs of this restructuring plan, which was substantially completed during fiscal 2000. Subsequent to fiscal 2000, the remaining accrued restructuring costs were primarily comprised of the estimated remaining costs necessary to exit the leased office space. During the quarter ended November 27, 2004, we exercised an option, available under our master lease agreement, to purchase, and simultaneously sell, the office facility to the current tenant, an unrelated party. The negotiated purchase price with the landlord, a partnership in which the majority of the interests were owned by a Vice-Chairman of the Board of Directors and certain other employees and former employees of the Company, was $14.0 million and the tenant agreed to purchase the property for $12.5 million. These prices were within the range of estimated fair values of the buildings as determined by an independent appraisal obtained by the Company. We paid the difference between the sale and purchase prices, plus other closing costs, which were included as a component of the restructuring plan accrual. After accounting for the sale transaction, the remaining fiscal 1999 restructuring costs, which totaled $0.3 million, were credited to operating expenses in the Company’s condensed consolidated statement of operations.

Depreciation and Amortization - Depreciation expense decreased $2.3 million, or 34 percent, compared to fiscal 2004 primarily due to the full depreciation or disposal of certain property and equipment balances and the effects of significantly reduced capital expenditures during preceding fiscal years. Based upon these events and current capital spending trends, we expect that depreciation expense will continue to decline compared to prior periods during the remainder of fiscal 2005.

Amortization expense on definite-lived intangible assets totaled $2.1 million for the two quarters ended February 26, 2005 and February 28, 2004. We currently expect intangible asset amortization expense to total $4.2 million in fiscal 2005.

Income Taxes

The provision for income taxes was $1.8 million for each of the two quarters ended February 26, 2005 and February 28, 2004. Our income tax provision during these periods was primarily due to taxable income in certain foreign tax jurisdictions for which we were unable to offset the tax liabilities in these jurisdictions with our domestic operating loss. At February 26, 2005, given our history of significant operating losses, we had provided a valuation allowance against substantially all of our domestic deferred income tax assets.


LIQUIDITY AND CAPITAL RESOURCES

Historically, our primary sources of capital have been net cash provided by operating activities, line-of-credit financing, long-term borrowings, asset sales, and the issuance of preferred and common stock. We currently rely primarily upon cash flows from operating activities and cash on hand to maintain adequate liquidity and working capital levels. Following the completion of our seasonally strong second fiscal quarter, at February 26, 2005 we had $47.3 million of cash, cash equivalents, and short-term investments compared to $41.9 million at August 31, 2004. Our net working capital (current assets less current liabilities) was $43.9 million at February 26, 2005 compared to $33.8 million at August 31, 2004. The following discussion is a description of the primary factors affecting our cash flows and their effects upon our liquidity and capital resources during the two quarters ended February 26, 2005.

Cash Flows From Operating Activities

During the two quarters ended February 26, 2005, our net cash provided by operating activities increased to $11.0 million compared to $3.3 million for the same period of the prior year. Our primary source of cash from operating activities was the sale of goods and services to our customers in the normal course of business. As previously mentioned, our second fiscal quarter has historically realized seasonally strong sales as many of our clients renew their planners on a calendar basis and purchase gift items during the holiday season. Our primary uses of cash for operating activities are payments to suppliers for materials used in products sold, payments for direct costs necessary to conduct training programs, and payments for selling, general, and administrative expenses. During the two quarters ended February 26, 2005, one of our significant uses of cash for operating activities consisted of payments made to vendors and suppliers related to inventory purchases for our seasonally busy months of November, December, and January, which was reflected by a significant reduction in our accounts payable balance. Our overall cash flows from operating activities improved due to increased sales, improved margins on sales, and lower operating costs than in the previous year.

Our third fiscal quarter, which consists of March, April, and May has historically had reduced sales and correspondingly decreased cash provided by operating activities, compared to our first and second quarters of our fiscal year. We believe that efforts to optimize working capital balances combined with existing and planned cost-cutting initiatives, and sales stabilization efforts, including sales of new products and services, will improve our cash flows from operating activities in future periods. However, the success of these efforts is dependent upon numerous factors, many of which are not within our control.

Cash Flows From Investing Activities and Capital Expenditures

Net cash used for investing activities totaled $2.8 million for the two quarters ended February 26, 2005. Our primary uses of cash for investing activities were the purchase of short-term investments totaling $1.7 million and the purchase of property and equipment, which consisted primarily of computer hardware, software, and leasehold improvements in retail stores.

During the quarter ended February 26, 2005, we entered into a preliminary agreement to sell and leaseback our corporate headquarters facility, located in Salt Lake City, Utah. In connection with the sale, we will enter into a 20-year master lease agreement with the purchaser, a non-related private investment group. Under the preliminary terms of the agreement, we will have six five-year options to renew the master lease agreement and we could therefore maintain our operations at the current location for the next 50 years. We currently expect that our net proceeds from the sale, after transaction costs, will be approximately $32 million. A corresponding financing obligation will be recognized in our consolidated financial statements for the sale price of the headquarters facility. The completion of the sale is subject to customary conditions, including a due diligence review, survey, and other related closing conditions.

Cash Flows From Financing Activities

Net cash used for financing activities during the quarter ended February 26, 2005 totaled $4.4 million. Our primary use of cash for financing activities was the payment of accrued Series A preferred stock dividends, which totaled $4.4 million during fiscal 2005.

Contractual Obligations

The Company has not structured any special purpose or variable interest entities, or participated in any commodity trading activities, which would expose us to potential undisclosed liabilities or create adverse consequences to our liquidity. Required contractual payments primarily consist of payments to EDS for outsourcing services related to information systems, warehousing and distribution, and call center operations; minimum rent payments for retail store and sales office space; cash payments for Series A preferred stock dividends; monitoring fees paid to a Series A preferred stock investor; and mortgage payments on certain buildings and property. There have been no significant changes to our expected required contractual obligations from those disclosed at August 31, 2004.  However, if the Company completes the expected sale of its corporate headquarters facility, it would incur a substantial ongoing lease obligation.

 
Other Items

Management Common Stock Loan Program - The Company is the creditor for a loan program that provided the capital to allow certain management personnel the opportunity to purchase shares of our common stock. In May 2004, our Board of Directors approved modifications to the terms of the management stock loans. While these changes had significant implications for most management stock loan program participants, the Company did not formally amend or modify the stock loan program notes. Rather, the Company is foregoing certain of its rights under the terms of the loans in order to potentially improve the participant’s ability to pay, and the Company’s ability to collect, the outstanding balances of the loans. Based upon guidance found in EITF Issue 00-23, Issues Related to the Accounting for Stock Compensation under APB Opinion No. 25 and FASB Interpretation No. 44, and EITF Issue 95-16, Accounting for Stock Compensation Agreements with Employer Loan Features under APB Opinion No. 25, we determined that the management common stock loans should be accounted for as non-recourse stock compensation instruments due to the modifications approved in May 2004 and their effects to the Company and the loan participants. While this accounting treatment does not alter the legal rights associated with the loans to the employees, the modifications to the terms of the loans were deemed significant enough to adopt the non-recourse accounting model as described in EITF 00-23. As a result of this accounting treatment, the remaining carrying value of the notes and interest receivable related to financing common stock purchases by related parties, which totaled $7.6 million prior to the loan term modifications, was reduced to zero with a corresponding reduction in additional paid-in capital.

We currently account for the management common stock loans as variable stock option arrangements. Compensation expense will be recognized when the fair value of the common stock held by the loan participants exceeds the contractual principal and accrued interest on the loans (approximately $47.5 million at February 26, 2005) or the Company takes action on the loans that in effect constitutes a repricing of an option. This accounting treatment also precludes the Company from reversing the amounts expensed as additions to the loan loss reserve, totaling $29.7 million, which were recognized in prior periods. As a result of these loan program modifications, the Company hopes to increase the total value received from loan participants; however, the inability of the Company to collect all, or a portion, of these receivables could have an adverse impact upon its financial position and future cash flows compared to full collection of the loans. Subsequent to February 26, 2005, the Company collected $0.8 million, which represented payment in full, from an officer and members of the Board of Directors that were required to repay their loans on March 30, 2005.  The Board of Directors approved loan modifications for a former executive officer and a former director substantially similar to loan modifications previously granted to other loan participants in the management stock loan program described above.

Availability of Future Capital Resources - Going forward, we will continue to incur costs necessary for the operation of the business. We anticipate using cash on hand, cash provided by operating activities, on the condition that we can continue to generate positive cash flows from operations, and other financing alternatives, if necessary, for these expenditures. We anticipate that our existing capital resources will be adequate to enable us to maintain our operations for at least the upcoming twelve months. Our ability to maintain adequate capital for future operations is dependent upon a number of factors, including sales trends, our ability to contain costs, levels of capital expenditures, collection of accounts receivable, and other factors. Some of the factors that influence our operations are not within our control, such as economic conditions and the introduction of new technology and products by our competitors. We will continue to monitor our liquidity position and may pursue additional financing alternatives, if required, to maintain sufficient resources for future operating and capital requirements. However, there can be no assurance such financing alternatives will be available to us on acceptable terms.
 
 

USE OF ESTIMATES AND CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America. The significant accounting polices that we used to prepare our consolidated financial statements are outlined in Note 1 to the consolidated financial statements, which are presented in Part II, Item 8 of our Annual Report on Form 10-K for the fiscal year ended August 31, 2004. Some of those accounting policies require us to make estimates and assumptions that affect the amounts reported in our consolidated financial statements. Management regularly evaluates its estimates and assumptions and bases those estimates and assumptions on historical experience, factors that are believed to be reasonable under the circumstances, and requirements under accounting principles generally accepted in the United States of America. Actual results may differ from these estimates under different assumptions or conditions, including changes in economic conditions and other circumstances that are not in our control, but which may have an impact on these estimates and our actual financial results.

The following items require the most significant judgment and often involve complex estimates:

Revenue Recognition

We derive revenues primarily from the following sources:

·  
Products - We sell planners, binders, planner accessories, handheld electronic devices, and other technology related products that are primarily sold through our CSBU channels.

·  
Training and Services - We provide training and consulting services to both organizations and individuals in strategic execution, leadership, productivity, goal alignment, sales force performance, and communication effectiveness skills. These training programs and services are primarily sold through our OSBU channels.

The Company recognizes revenue when: 1) persuasive evidence of an agreement exists, 2) delivery of product has occurred or services have been rendered, 3) the price to the customer is fixed and determinable, and 4) collectibility is reasonably assured. For product sales, these conditions are generally met upon shipment of the product to the customer or by completion of the sale transaction in a retail store. For training and service sales, these conditions are generally met upon presentation of the training seminar or delivery of the consulting services.

Some of our training and consulting contracts contain multiple deliverable elements that include training along with other products and services. In accordance with EITF Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, sales arrangements with multiple deliverables are divided into separate units of accounting if the deliverables in the sales contract meet the following criteria: 1) the delivered training or product has value to the client on a standalone basis; 2) there is objective and reliable evidence of the fair value of undelivered items; and 3) delivery of any undelivered item is probable. The overall contract consideration is allocated among the separate units of accounting based upon their fair values.  If the fair value of all undelivered elements exits, but fair value does not exist for one or more delivered elements, the residual method is used. Under the residual method, the amount of consideration allocated to the delivered items equals the total contract consideration less the aggregate fair value of the undelivered items. Fair value of the undelivered items is based upon the normal pricing practices for the Company’s existing training programs, consulting services, and other products, which are generally the prices of the items when sold separately.

Revenue is recognized on software sales in accordance with Statement of Position (SOP) 97-2, Software Revenue Recognition as amended by SOP 98-09. SOP 97-2, as amended, generally requires revenue earned on software arrangements involving multiple elements such as software products and support to be allocated to each element based the relative fair value of the elements based on vendor specific objective evidence (VSOE). The majority of the Company’s software sales have multiple elements, including a license and post contract customer support (PCS). Currently the Company does not have VSOE for either the license or support elements of its software sales. Accordingly, revenue is deferred until the only undelivered element is PCS and the total arrangement fee is recognized ratably over the support period.

Revenue is recognized as the net amount to be received after deducting estimated amounts for discounts and product returns.

 
Accounts Receivable Valuation

Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts represents our best estimate of the amount of probable credit losses in the existing accounts receivable balance. We determine the allowance for doubtful accounts based upon historical write-off experience and current economic conditions and we review the adequacy of our allowance for doubtful accounts on a regular basis. Receivable balances past due over 90 days, which exceed a specified dollar amount, are reviewed individually for collectibility. Account balances are charged off against the allowance after all means of collection have been exhausted and the probability for recovery is considered remote. We do not have any off-balance sheet credit exposure related to our customers.

Inventory Valuation

Inventories are stated at the lower of cost or market with cost determined using the first-in, first-out method. Our inventories are comprised primarily of dated calendar products and other non-dated products such as binders, handheld electronic devices, stationery, training products, and other accessories. Provision is made to reduce excess and obsolete inventories to their estimated net realizable value. In assessing the realization of inventories, we make judgments regarding future demand requirements and compare these assessments with current and committed inventory levels. Inventory requirements may change based on projected customer demand, technological and product life cycle changes, longer or shorter than expected usage periods, and other factors that could affect the valuation of our inventories.

Indefinite-Lived Intangible Assets

Intangible assets that are deemed to have an indefinite life are not amortized, but rather are tested for impairment on an annual basis, or more often if events or circumstances indicate that a potential impairment exists. The Covey trade name intangible asset has been deemed to have an indefinite life. This intangible asset is assigned to the Organizational Solutions Business Unit and is tested for impairment using the present value of estimated royalties on trade name related revenues, which consist primarily of training seminars, international licensee royalties, and related products. If forecasts and assumptions used to support the realizability of our indefinite-lived intangible asset change in the future, significant impairment charges could result that would adversely affect our results of operations and financial condition.

Impairment of Long-Lived Assets

Long-lived tangible assets and definite-lived intangible assets are reviewed for possible impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. We use an estimate of undiscounted future net cash flows of the assets over the remaining useful lives in determining whether the carrying value of the assets is recoverable. If the carrying values of the assets exceed the anticipated future cash flows of the assets, we recognize an impairment loss equal to the difference between the carrying values of the assets and their estimated fair values. Impairment of long-lived assets is assessed at the lowest levels for which there are identifiable cash flows that are independent from other groups of assets. The evaluation of long-lived assets requires us to use estimates of future cash flows. If forecasts and assumptions used to support the realizability of our long-lived tangible and definite-lived intangible assets change in the future, significant impairment charges could result that would adversely affect our results of operations and financial condition.

Income Taxes

The calculation of our income tax provision or benefit, as applicable, requires estimates of future taxable income or losses. During the course of the fiscal year, these estimates are compared to actual financial results and adjustments may be made to our tax provision or benefit to reflect these revised estimates.

Our history of significant operating losses precludes us from demonstrating that it is more likely than not that the related benefits from deferred income tax deductions and foreign tax carryforwards will be realized. Accordingly, we recorded valuation allowances on our deferred income tax assets. These valuation allowances are based on estimates of future taxable income or losses that may or may not be realized.


NEW ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board (FASB) approved Statement No. 123R, Share-Based Payment. Statement 123R sets accounting requirements for “share-based” compensation to employees, including employee stock purchase plans, and requires companies to recognize in the income statement the grant-date fair value of stock options and other equity-based compensation. The Company currently accounts for its stock-based compensation using the intrinsic method as defined in Accounting Principles Board (APB) Opinion No. 25 and accordingly, we have not recognized any expense for our stock option plans or employee stock purchase plan in our consolidated financial statements. Currently, we provide disclosures about the pro forma compensation expense from stock based awards, which is based upon a Black-Scholes option pricing model. Although Statement 123R does not express a preference for a type of valuation model, we intend to reexamine our valuation methodology and the corresponding support for the assumptions that underlie the valuation of stock-based awards prior to our adoption of Statement 123R. This statement is effective for interim or annual periods beginning after June 15, 2005, and will thus be effective for our first quarter of fiscal 2006. Upon adoption, we intend to use the modified prospective transition method. Under this method, awards that are granted, modified, or settled after the date of adoption will be measured and accounted for in accordance with Statement 123R. Unvested equity-classified awards that were granted prior to the effective date will continue to be accounted for in accordance with Statement 123, except that compensation expense amounts will be recognized in the income statement. We are currently in the process of further analyzing this new pronouncement and have not yet determined the impact on our financial statements.

In November 2004, the FASB approved Statement No. 151, Inventory Costs an Amendment of ARB No. 43, Chapter 4. Statement No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) and requires that those items be recognized as a current period expense regardless of whether they meet the criteria of “so abnormal.” This statement is effective for interim or annual periods beginning after June 15, 2005 and will thus be effective for our first quarter of fiscal 2006. We are currently in the process of analyzing the accounting requirements under this new pronouncement and have not yet determined its impact on our financial statements.


ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

MARKET RISK OF FINANCIAL INSTRUMENTS

The primary financial instrument risks to which the Company is exposed are fluctuations in foreign currency exchange rates and interest rates. To manage risks associated with foreign currency exchange and interest rates, we make limited use of derivative financial instruments. Derivatives are financial instruments that derive their value from one or more underlying financial instruments. As a matter of policy, our derivative instruments are entered into for periods consistent with the related underlying exposures and do not constitute positions that are independent of those exposures. In addition, we do not enter into derivative contracts for trading or speculative purposes, nor are we party to any leveraged derivative instrument. The notional amounts of derivatives do not represent actual amounts exchanged by the parties to the instrument, and, thus, are not a measure of exposure to us through our use of derivatives. Additionally, we enter into derivative agreements only with highly rated counterparties and we do not expect to incur any losses resulting from non-performance by other parties.

Foreign Currency Sensitivity

Due to the global nature of the Company’s operations, we are subject to risks associated with transactions that are denominated in currencies other than the United States dollar, which creates exposure to foreign currency exchange risk. The objective of our foreign currency risk management activities is to reduce foreign currency risk in the consolidated financial statements. In order to manage foreign currency risks, we make limited use of foreign currency forward contracts and other foreign currency related derivative instruments. Although we cannot eliminate all aspects of our foreign currency risk, we believe that our strategy, which includes the use of derivative instruments, can reduce the impacts of foreign currency related issues on our consolidated financial statements.

 
During the quarter and two quarters ended February 26, 2005, we utilized foreign currency forward contracts to manage the volatility of certain intercompany financing transactions and other transactions that are denominated in foreign currencies. Because these contracts do not meet specific hedge accounting requirements, gains and losses on these contracts, which expire on a quarterly basis, are recognized currently and are used to offset a portion of the gains or losses of the related accounts. The gains and losses on these contracts were recorded as a component of SG&A expense in the Company’s consolidated statements of operations and resulted in the following net losses for the periods indicated (in thousands):
 
   
Quarter Ended
 
Two Quarters Ended
 
   
February 26,
2005
 
February 28,
2004
 
February 26,
2005
 
February 28,
2004
 
Losses on foreign exchange contracts
 
$
(58
)
$
(148
)
$
(353
)
$
(539
)
Gains on foreign exchange contracts
   
3
   
-
   
3
   
24
 
Net loss on foreign exchange contracts
 
$
(55
)
$
(148
)
$
(350
)
$
(515
)

 
At February 26, 2005, the fair value of these contracts, which was determined using the estimated amount at which contracts could be settled based upon forward market exchange rates, was insignificant. The notional amounts of our foreign currency sell contracts that did not qualify for hedge accounting were as follows at February 26, 2005 (in thousands):
 
 
 
 
Contract Description
 
Notional Amount in Foreign Currency
 
 
Notional Amount in U.S. Dollars
 
           
Australian Dollars
   
1,760
 
$
1,366
 
Mexican Pesos
   
9,200
   
812
 
Japanese Yen
   
40,000
   
391
 


During the quarter and two quarters ended February 26, 2005, we also entered into foreign currency forward contracts that were designed to manage foreign currency risks related to the value of our net investment in foreign operations located in Canada, Japan, and the United Kingdom. These three offices comprise the majority of our net investment in foreign operations. These foreign currency forward instruments, which expire on a monthly basis, qualified for hedge accounting and corresponding gains and losses were recorded as a component of other comprehensive income in the Company’s consolidated balance sheet. The gains and losses on these contracts were as follows for the periods presented (in thousands):

   
Quarter Ended
 
Two Quarters Ended
 
   
February 26,
2005
 
February 28,
2004
 
February 26,
2005
 
February 28,
2004
 
Losses on net investment hedge contracts
 
$
(72
)
$
-
 
$
(384
)
$
-
 
Gains on net investment hedge contracts
   
46
   
-
   
66
   
-
 
Net loss on net investment hedge contracts
 
$
(26
)
$
-
 
$
(318
)
$
-