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Form
10-Q for IMERGENT INC 5-Nov-2004 Quarterly Report Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations This management's discussion and analysis of financial condition and results of operations and other portions of this Quarterly Report on Form 10-Q contain forward-looking information that involves risks and uncertainties. Our actual results could differ materially from those anticipated by this forward-looking information. Factors that could cause or contribute to such differences include, but are not limited to, those discussed or referred to in the Annual Report on Form 10-K for the year ended June 30, 2004, filed on September 10, 2004, under the heading Information Regarding Forward-Looking Statements and elsewhere. Investors should review this quarterly report on Form 10-Q in combination with our Annual Report on Form 10-K in order to have a more complete understanding of the principal risks associated with an investment in our common stock. This management's discussion and analysis of financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this document. GENERAL Fluctuations in Quarterly Results and Seasonality In view of the rapidly evolving nature of our business and the market we serve, we believe that period to period comparisons of our operating results, including our gross profit and operating expenses as a percentage of revenues and cash flow, are not necessarily meaningful and should not be relied upon as an indication of future performance. We experience seasonality in our business. Our fiscal year ends each June 30. Revenues from our core business during the first and second fiscal quarters tend to be lower than revenues in our third and fourth quarters. We believe this to be attributable to summer vacations and the Thanksgiving and December holiday seasons that occur during our first and second quarters. Certain prior period amounts have been reclassified to conform to current year presentation. Critical Accounting Policies and Estimates Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("US GAAP") as applicable to interim financial statements and form the basis for the following discussion and analysis on critical accounting policies and estimates. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On a regular basis we evaluate our estimates and assumptions. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Senior management has discussed the development, selection and disclosure of these estimates with the Board of Directors and its Audit Committee. There are currently five members of the Board of Directors, three of whom make up the Audit Committee. The Board of Directors has determined that each member of the Audit Committee qualifies as an independent director and that the chairman of the Audit Committee qualifies as an "audit committee financial expert" as defined under the rules adopted by the SEC. A summary of our significant accounting policies is set out in Note 2 to our Consolidated Financial Statements as found in our Form 10-K for the year ended June 30, 2004. We believe the critical accounting policies described below reflect our more significant estimates and assumptions used in the preparation of our consolidated financial statements. The impact and any associated risks on our business that are related to these policies are also discussed throughout this Management's Discussion and Analysis of Financial Condition and Results of Operations where such policies affect reported and expected financial results. Revenue Recognition On October 1, 2000, the Company started selling a license to use a new product called the StoresOnline Software ("SOS"). The SOS is a web based software product that enables the customer to develop their Internet
website without additional assistance from the Company. When a customer purchases a SOS license at one of the Company's Internet workshops, he or she receives a CD-ROM containing programs to be used with their computer and a password and instructions that allow immediate access to the Company's website where all the necessary software programs and tools are located to complete the construction of the customer's website. When completed, the website can be hosted with the Company or any other provider of such services. If they choose to host with the Company there is an additional setup and hosting fee (currently $150) for publishing and 12 months of hosting. This fee is deferred at the time it is paid and recognized during the subsequent 12 months. A separate file is available and can be used if the customer decides to create their website on their own completely without access to the Company website and host their site with another hosting service. The revenue from the sale of the SOS license is recognized when the product is delivered to the customer and the three-day rescission period expires. The Company accepts cash and credit cards as methods of payment and the Company offers 24-month installment contracts to customers who prefer an Extended Payment Term Arrangement (EPTA). The Company offers these contracts to all workshop attendees not wishing to use a check or credit card provided they complete a credit application, give permission for the Company to independently check their credit and are willing to make an appropriate down payment. EPTAs were either sold to third party financial institutions, generally with recourse, for cash on a discounted basis, or carried on the Company's books as a receivable. Beginning in May 2004 the Company stopped selling EPTA's with any recourse provisions. The EPTAs generally have a twenty-four month term. For more than six years the Company has offered its customers the payment option of a long-term installment contract and has a history of successfully collecting under the original payment terms without making concessions. During fiscal years ended June 30, 1999 through 2004, the Company has collected or is collecting approximately 70% of all EPTAs issued to customers. Not all customers live up to their obligations under the contracts. The Company makes every effort to collect on the EPTAs, including the engagement of professional collection services. Despite reasonable efforts, approximately 47% of all EPTAs not sold to third party financial institutions become uncollectible during the life of the contract. All uncollectible EPTAs are written off against an allowance for doubtful accounts. The allowance is established at the time of sale based on our five-year history of extending EPTAs and revised periodically based on current experience and information. The revenue generated by sales to EPTA customers is recognized when the product is delivered to the customer, the contract is signed and any rescission period lapses. At that same time an allowance for doubtful accounts is established. This procedure has been in effect for all periods presented. The American Institute of Certified Public Accountants Statement of Position 97-2 ("SOP 97-2") states that revenue from the sale of software should be recognized when the following four specific criteria are met: 1) persuasive evidence of an arrangement exists, 2) delivery has occurred, 3) the fee is fixed and determinable and 4) collectibility is probable. All of these criteria are met when a customer purchases the SOS product and the three-day rescission period expires. The customer signs one of the Company's order forms, and a receipt acknowledging receipt and acceptance of the product. As is noted on the order and acceptance forms the customer has three days to rescind the order. Once the rescission period expires, all sales are final and all fees are fixed and determinable. The Company also offers its customers, through telemarketing sales following the workshop, certain products intended to assist the customer in being successful with their business. These products include a live chat capability for the customer's own website and web traffic building services. Revenues from these products are recognized when delivery of the product has occurred. The Company receives a commission and recognizes this revenue net of the selling and marketing costs. Allowance for Doubtful Accounts We record an allowance for doubtful accounts and disclose the associated expense as a separate line item in operating expenses. The allowance, which is netted against our current and long term accounts receivable balances on our consolidated balance sheets, totaled approximately $11.5 million and $9.0 million as of September 30, 2004 and June 30, 2004, respectively. The amounts represent estimated losses resulting from the inability of our customers to make required payments. The estimates are based on historical bad debt write-offs, specific identification of probable bad debts based on collection efforts, aging of accounts receivable and other known factors. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
Valuation of Long-Lived Assets Including Goodwill and Purchased Assets We review property, equipment, goodwill and purchased intangible assets for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. This review is conducted as of December 31st of each year or more frequently if necessary. Our asset impairment review assesses the fair value of the assets based on the future cash flows the assets are expected to generate. An impairment loss is recognized when estimated undiscounted future cash flows expected to result from the use of the asset plus net proceeds expected from the disposition of the asset (if any) are less than the carrying value of the asset. This approach uses our estimates of future market growth, forecasted revenue and costs, expected period the assets will be utilized and appropriate discount rates. When an impairment is identified, the carrying amount of the asset is reduced to its estimated fair value. Income Taxes In preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating current tax liabilities together with assessing temporary differences resulting from differing treatment of items for tax and financial reporting purposes. These differences result in deferred tax assets and liabilities. Our deferred tax assets consist primarily of the future benefit of net operating losses carried forward. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We have considered historical operations and current earnings trends, future market growth, forecasted earnings, estimated future taxable income, the mix of earnings in the jurisdictions in which we operate and prudent and feasible tax planning strategies in determining the need for a valuation allowance. In the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to earnings in the period such determination is made. Likewise, if we later determine that it is more likely than not that the net deferred tax assets would be realized, the previously provided valuation allowance, if any, would be reversed. At June 30, 2003 we had recognized a tax valuation allowance of $19.3 million against our deferred tax assets. As of March 31, 2004, we determined that it was more likely than not that $16.7 million, or all but approximately $2.6 million of the deferred tax assets would be realized. This determination was based on current projections of future taxable income when taking into consideration limitations on the utilization of net operating loss carry forwards ("NOL") imposed by Section 382 of the Internal Revenue Code ("Section 382"). Section 382 imposes limitations on a corporation's ability to utilize its NOLs if it experiences an "ownership change". In general terms, an ownership change results from transactions increasing the ownership of certain stockholders in the stock of a corporation by more than 50 percentage points over a three-year period. Since our formation, we have issued a significant number of shares, and purchasers of those shares have sold some of them, with the result that two changes of control, as defined by Section 382, have occurred. As a result of the most recent ownership change, utilization of our NOLs is subject to an annual limitation under Section 382 determined by multiplying the value of our stock at the time of the ownership change by the applicable long-term tax-exempt rate resulting in an annual limitation amount of approximately $127,000. Any unused annual limitation may be carried over to later years, and the amount of the limitation may under certain circumstances be increased by the "recognized built-in gains" that occur during the five-year period after the ownership change (the "recognition period"). Based on an independent valuation of our company as of April 3, 2002, we have approximately $15 million of recognized built-in gains. Additionally, based on a valuation of our company as of June 25, 2000, which evaluation was completed during the quarter ended March 31, 2004, we also determined the earlier ownership change resulted in built-in gains that allow us to utilize our entire NOL. Recently Issued Accounting Pronouncements In December 2003, the SEC issued Staff Accounting Bulletin No. 104 ("SAB 104"), "Revenue Recognition", which supercedes Staff Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in Financial Statements." The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, which was superceded as a result of the issuance of Emerging Issues Task Force 00-21 ("EITF 00-21"), "Accounting for Revenue Recognition in Financial Statements - Frequently Asked Questions and Answers" document. While the wording of SAB 104 has changed to reflect the
issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The adoption of SAB 104 did not have a material impact on our consolidated financial position, results of operations or cash flows. RESULTS OF OPERATIONS Three-month period ended September 30, 2004 compared to the three-month period ended September 30, 2003. Revenue Our fiscal year ends on June 30 of each year. Revenues for the three-month period ended September 30, 2004 increased to $23,708,737 from $18,839,683 in the three-month period ended September 30, 2003, an increase of 26%. Revenues generated at our Internet training workshops for the periods in both fiscal years were from the sale of the SOS product as described in Critical Accounting Policies and Estimates above. Revenues also include fees charged to attend the workshop, web traffic building products, mentoring, consulting services and access to credit card transaction processing interfaces. We expect future, operating revenue to be generated principally following a business model similar to the one used in our fiscal year that ended June 30, 2004. The Internet environment continues to evolve, and we intend to offer future customers new products as they are developed. We anticipate that our offering of products and services will evolve as some products are dropped and are replaced by new and sometimes innovative products intended to assist our customers achieve success with their Internet-related businesses. The increase in revenues from our first fiscal quarter ended September
30, 2004 compared to the three-month period ended September 30, 2003
can be attributed to various factors. There was an increase in the
number of Internet training workshops conducted during the current
fiscal quarter. The number increased to Gross Profit Gross profit is calculated as revenue less the cost of revenue, which consists of the cost to conduct Internet training workshops, to program customer storefronts, to provide customer technical support and the cost of tangible products sold. Gross profit for the three-month ended September 30, 2004 increased to $17,133,461 from $14,477,981 for the same three-month period in the prior year. The increase in gross profit primarily reflects the increased revenue during the period. Gross profit as a percent of revenue for quarter ended September 30, 2004 decreased to 72% compared to 77% for the quarter ended September 31, 2003 primarily as a result of additional personnel costs on our workshop teams related to the anticipated increase in workshop teams from four to five. The fifth workshop team was hired and trained during the quarter ended September 30, 2004 and was deployed on November 1, 2004. Research and Development Research and development expenses consist primarily of payroll and related expenses. Research and development expenses in the current fiscal quarter were $139,464 compared to $76,694 in the quarter ended
September 30, 2003. In both periods these expenses consisted of work on the StoresOnline, version 4, product that is used in the StoresOnline Software sold at our Internet training workshops and the improvement of our internal database used by management to control operations. Additionally, during the current fiscal quarter, research and development expenses included payroll and consulting expenses incurred in the pursuit of partnership relationships for the distribution of SOS. We intend to make enhancements to our technology as new methods and business opportunities present themselves. We will undertake additional development projects as the needs are identified and as the funds to undertake the work are available. Selling and Marketing Selling and marketing expenses consist of payroll and related expenses for sales and marketing, the cost of advertising, promotional and public relations expenditures and related expenses for personnel engaged in sales and marketing activities. Selling and marketing expenses for the quarter ended September 30, 2004 increased to $6,541,423 from $4,440,984 in the quarter ended September 30, 2003. The increase in selling and marketing expenses is primarily attributable to the increase in the number of workshops held during the current year and the associated expenses including advertising and promotional expenses necessary to attract the attendees. Advertising expenses for the three-month period ended September 30, 2004 were approximately $3.0 million compared to approximately $2.1 million in the three-month period ended September 30, 2003. Selling and marketing expenses as a percentage of sales were 28% of revenues for the first quarter of FY 2005 compared to 24% in the first quarter of FY 2004. The increase in selling and marketing expenses as a percentage of sales in the current period compared to the prior period relates primarily to sales and marketing expenses incurred to test markets in non-English speaking countries in Europe and Asia. General and Administrative General and administrative expenses consist of payroll and related expenses for executive, accounting and administrative personnel, professional fees, finance company discounts and other general corporate expenses. General and administrative expenses for the three-month period ended September 30, 2004 increased to $2,044,489 from $1,862,392 in the comparable period of the previous fiscal year. This increase is attributable to increases in salaries and fringe benefits and accounting services needed to support the general growth in the operations of the Company. This increase was partially offset by a reduction in finance company discounts. Finance company discounts arise in connection with our practice of accepting 24-month installment contracts from our customers as one of several methods of payment. Some of these contracts have historically been sold to finance companies at a discount, which generally ranged between 15% and 25% depending upon the credit worthiness of our customer. Additionally, we outsource the servicing of these 24-month installment contracts for a fee, generally seven to ten percent of cash collected. The finance company discounts decreased during the current period compared to the same quarter last year due to the fact that the Company no longer sells these contracts due to the liquidity arising from the line of credit that was obtained during calendar 2004. General and administrative expenses as a percentage of revenues decreased during the quarter ended September 30, 2004 to 9% from 10% in the same quarter of the prior fiscal year. We anticipate that general and administrative expenses will increase in future years as our business grows. Bad Debt Expense Bad debt expense consists mostly of actual and anticipated losses resulting from the extension of credit terms to our customers when they purchase products from us. We encourage customers to pay for their purchases by check or credit card since these are the least expensive methods of payment for our customers, but we also offer installment contracts with payment terms up to 24 months. We offer these contracts to all workshop attendees not wishing to use a check or credit card provided they complete a credit application, give us permission to independently check their credit and are willing to make an appropriate down payment of from 5% to 10% of the purchase price. We out-source the collection activity of these installment contracts. Our collection experience with these 24-month contracts is satisfactory given the low marginal cost associated with these sales and that the down
payment received by us at the time the contract is entered into exceeds the cost of the delivered products. Since all other expenses relating to the sale, such as salaries, advertising, meeting room expense, travel, etc., have already been incurred, we believe there is a good business reason for extending credit on these terms. Bad debt expense was $6,398,401 in the first quarter of FY 2005 compared to $6,220,234 in the comparable period of the prior fiscal year. This increase is due primarily to an increase in the number of installment contracts entered into as a result of the increase in revenue. We have begun to have access to much more detailed information from the finance companies that service the installment contracts, and we have also had more historical data with which to estimate the appropriate bad debt reserve. Bad debt expense as a percentage of revenue decreased during the quarter ended September 30, 2004 to 27% compared to 33% in the same quarter of the prior fiscal year. We believe that bad debt expense in future years will gradually decline as a percentage of revenues due to our continued gradual improvement in collection history. We believe the allowance for doubtful accounts of approximately $11.5 million at September 30, 2004 is adequate to cover all future losses associated with the contracts in our accounts receivable as of September 30, 2004. During the first quarter of FY 2005 workshop sales financed by installment contracts were approximately $12.6 million compared to approximately $10.5 million in the first quarter of the prior fiscal year. As a percentage of workshop sales, installment contracts were 63% in the first quarter of FY 2005 compared to 61% in the first quarter of FY 2004. The table below shows the activity in our total allowance for doubtful accounts during the three-month period ended September 30, 2004:
Interest Income Interest income is derived from the installment contracts carried by the Company. Our contracts have an 18% simple interest rate and interest income for the three-month period ended September 30, 2004 was $786,330 compared to $275,244 in the comparable period of the prior fiscal year. The increase is primarily attributable to the increase in installment contracts receivable compared to the prior fiscal year. As our cash position has strengthened we have been able to carry more installment contracts rather than selling them at a discount to finance companies. Consequently, interest income has increased and administrative expenses have decreased as a percentage of revenue. The discount expenses incurred upon sale of the installment contracts are included in administrative expenses, as discussed above. Income Taxes At June 30, 2003 we had recognized a tax valuation allowance of $19.3 million against our deferred tax assets. As a result, no provision for income taxes was recognized during the quarter ended September 30, 2003 as it was not yet determined whether or not the deferred tax assets would be fully realizable but it was determined that the assets were sufficient enough to offset any income tax provision. As of March 31, 2004, we determined that it was more likely than not that $16.7 million, or all but $2.6 million of the deferred tax assets would be realized. This determination was based on current projections of future taxable income when taking into consideration limitations on the utilization of net operating loss carry forwards ("NOL") imposed by Section 382 of the Internal Revenue Code ("Section 382")and built-in gains as determined by an independent valuation of our company. Since March 31, 2004, we have recognized a provision for income taxes based upon the applicable federal and state tax rates. The majority of the income tax provision recognized reflects the utilization of the deferred tax assets recognized as of March 31, 2004. As the Company continues . . .
Contact: iMergent, Inc.
Rob Lewis, 801-431-4695 (CFO)
investor_relations@imergentinc.com
or
Lippert/Heilshorn & Assoc.
Steve Kuzmic, skuzmic@lhai.com 415-433-3777 (Investor Relations)
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